WHAT IS THE CARRY TRADE?

The carry trade is all about borrowing short-term in a weak currency and investing long term in a stronger one.  The stronger currency will generally be noted by rising interest rates.  The funding is short-term where the rates are apt to be lower, and the investing is long term where the rates are out near the high end of the yield curve.  The investor succeeds if the exchange rates between the funding and investing currencies do not change markedly over the course of the investment, or until the funding has been paid back.

An example:  An investor borrows money from a bank in Japan in yen, sells the yen and buys NZ dollars, and then invests the money in corporate bonds in New Zealand.  The funding rate in Japan might be less than 1%, but the investing rate in New Zealand might be as high as 8%.  The proceeds from New Zealand are then exchanged back into yen to pay off the interest and principal of the funding currency, rolling the short-term debt over as needed.  When the obligation in Japan is finished, the assets in New Zealand are home free—all done without tying up any other resources other than collateral for the loan.  By borrowing in yen and then selling it to buy NZ dollars for an investment, the market pressure has a tendency to keep the yen cheaper and the NZ dollar worth more.

The risks:  The carry trade brings some unusual risks with it.  There’s the obvious interest rate risk on the funding end, that interest rates in Japan will rise just as the investor needs to roll the short-term loan over.  Further, there’s the obvious risk of default on the investing end, where the NZ bonds suddenly become worthless.  But there’s another risk that might be even more dramatic—an increase in the funding currency’s value or a decline in the investing currency’s value owing to changes in the exchange rate.  This would upset the carry trade as the investor would need to consume more of the invested returns to pay off the funding.  Adverse changes in currency value could force the investor to unwind the investment prematurely at a loss.  Most investors involved in the carry trade have a solid appetite for risk and keep their eyes tuned in to changes in the applicable exchange rates.

What to look out for:  Higher interest rates in a currency have a tendency to keep savings and fixed income investments at home.  Further, they can draw in foreign capital, encouraging the carry trade.  When central banks push interest rates up, they generally are working to protect the domestic currency by keeping inflation in check.  Higher yields are often a product of a lack of domestic savings that would be needed to support current-account balances evolving from foreign trade.  If the domestic savings do not cover the current account, foreign capital might be needed, and higher yields would be required to obtain the foreign capital.  In Asian emerging markets, investors very often find current-account surpluses and also high amounts of domestic savings, thereby resulting in low domestic yields.  Russia, on the other hand, has high yields and a current-account surplus stemming from ultra conservative fiscal and monetary policies designed to prevent a reliance on foreign investment.

Trading currencies:  As currencies are bought and sold around the world, a weakening currency can be a sign of anxiety over impending domestic inflation.  Currency weakness has also figured into emerging market inflation.  The best way for central banks in emerging markets to stop or slow down inflation might be to push up interest rates thereby strengthening the emerging market currency.  A stronger currency would cause imported goods to have a higher cost and therefore less of a sales value, which would have a tendency to drive down inflation.  This would benefit the carry trade investor as long as the funding was moved into the investing currency before the central banks acted.  However, if inflation occurred in the funding currency, the carry trade investor could have a problem trying to move money from the investment currency back to the funding currency whose exchange rate has gone up.

Conclusion:  Successfully executed, the carry trade can enable an investor to achieve a substantial gain by letting the proceeds of the investment liquidate the loan on the funding side.  No other capital needs to be invested other than possibly collateral for the loan, and that capital would continue to grow in value while it’s being used.  Picture it this way:  you get an interest free cash advance of $10,000 from a credit card and invest it in notes that have pay 5% interest.  Six months later you’ll have $250 in interest and perhaps a capital gain from the notes.  You sell it all, and the proceeds would then be used to pay off the credit card balance, leaving you with nice return that appears out of thin air.  The carry trade is more or less self-liquidating, and safer if it’s in the same currency or between two currencies that don’t have major exchange rate differences.  Beware of the risks, though.

Sources:         Carrying On, by Buttonwood, The Economist, July 3, 2021.

                        Investopedia.