Is there anything in trading that is as simple as the axiom to buy low and sell high? Perhaps not; but there is something on a similar level: borrowing funds on the cheap and reinvesting at a higher yield. That is the foundation of the popularised carry trade in foreign exchange trading; and it seems just as obvious. However, as they say, if it were that easy everyone would be doing it. And, in this case, everyone would be a millionaire.
So where does the complication come into this otherwise straightforward approach? First we need to understand the mechanics to this trade. The idea is to ‘short’ a currency with a low benchmark yield (often measured through overnight swap rates, rather than the central bank rates most people refer to) and to ‘go long’ a currency with a high rate. For the spot FX trader, the yield differential is earned when long the higher rate currency; and charged when long the lower yield currency.
That is simple enough. Alone, this is an obvious trade that would produce notable returns. However, there are two sides to this coin: the yield earned or paid on the carry and the capital gains and losses we incur as the exchange rate fluctuates. To gain exposure to the yield income, we need to take a position in the underlying exchange rate. And, for most spot traders, this entails substantial leverage. This gearing works to increase the steady yield income that is made on a daily basis; but it also amplifies the influence of the exchange rate swings. This is particularly problematic now, considering volatility behind the exchange rate has been exceptionally high while global interest rates are substantially reduced as a means to encourage growth, ease debt burdens and stimulate lending. The chart below illustrates this issue. We have the AUDUSD exchange rate (which is exposed to significant fluctuations outside of just the yield considerations) alongside the Deutsche Bank Carry Trade Index. Yield differentials alone do not define this strategy.
This brings us to the first and most rudimentary consideration: risk versus reward. While we can reasonably define the ‘reward’ component of this trade (the carry does not change much from day to day); the ‘risk’ is highly variable. If the loss in the exchange rate is greater than the yield for the day, then the trade is ultimately a losing one. This is especially true when leverage enters the picture. Many banks and professional money managers measure risk not in speculative forecasts for assets and exchange rates but instead on the volatility they expect from the position (under the belief that a big market move can be unfavourable as readily as it is favourable). That said, we should certainly take into account our speculative bias for the exchange rate.
The risk / reward balance is not unique to the carry trade. It is the underpinning of all markets; and this connection offers a relatively straightforward analysis of whether a possible loss in the exchange rate exposure will offset the interest that can be earned. Given the fixed nature of the carry income and variable exchange rate risk; when traders are concerned that volatility will rise and capital will move away from investments, the result is an unwinding of carry trades. Part of this reversal of flow comes because it is simply expected that others will unwind their positions; and there is also the reality that market participants need to draw the capital out of this FX trade to place it in a safe place or cover losses in other exposures. In the end, this leads to a remarkably strong correlation between carry trade and global equities (as evidenced in the charts at right). Both are driven by expectations of ‘risk appetite’.
Moving forward, we should consider the global scene to assess what the carry trade holds in store. Starting on the reward or return side of the column, interest rate differentials around the world are rather anaemic. Australian and New Zealand dollars have the highest rates among liquid currencies; however both of these yields are under pressure as a global cooling in economic activity curbs activity locally and the threat of financial contagion from Europe strains nerves. This in itself wouldn’t necessarily be an issue as the potential for returns is drawn through the differential between the high and low rates. Yet, the low rates don’t have any further to fall as the US, Japanese and Swiss yields (all currencies used to fund carry trades during the good times) are essentially at zero. That means a global decline in rates will reduce spreads.
From the risk perspective, conditions are visibly worsening. The reduced capacity for return further amplifies the reality that the ‘reward’ component of the carry trade simply cannot compensate for the growing threat of a global financial crunch. Trouble seems to be growing out of the Euro Zone periphery countries; but the threat is truly a global one (similar to how the 2008/2009 crisis began in the US subprime market and spread from there). As fear takes over, volatility increases as panic is far more contagious than greed. The need to raise capital to cover margin on losses with other trades and the simple need to protect funds will draw capital out of the passive carry trade. This certainly looks like the path that the global financial markets are on now (not withstanding a few central bank interventions along the way).
Perhaps the carry trade isn’t as easy as it seems…
By DailyFX senior currency strategist John Kicklighter