Carry Trade

On the surface it a simple arbitrage between interest rates. Underneath, it determines the viability of a currency and, therefore, a nation and can rock the world. Again, the carry trade is an investment strategy involving basic arbitrage between interest rates. In essence the Carry Trade is about borrowing at a low interest rate and lending at a higher rate. This is at the heart of international relations, how banks operate and is at the heart of the forex markets and applies to any trade where one can borrow low and lend high.

So, let’s get into this sentiment indicator to find out if, how and when to use it. Let’s start with how it rocks the world. Then some on the unwinding of a carry trade and, finally, I’ll include some examples from other countries and markets.

Global Economics.

On the global scale, the carry trade is the same. The interest rate offered through a central bank will effect where money comes from and where it flows to. For instance, if the Fed gives a low interest on borrowed funds, investors/traders will borrow from the U.S. then look to loan the money in a country where the interest rate is higher.

This is the simplified view. In reality there are, of course, many other factors to be considered:

Is the country being borrowed from going to maintain the low rate?
Is the country being lent to going to be able to pay the interest and repay the loan?

There are advantages for the country having the lower interest rate. With their funds being borrowed, their currency tends to be weak because it is being sent to another country for investment. For instance, if the USD is weak, our US goods are cheaper. If the USD is being invested in countries using, for instance, the Euro, Europe will have a stronger currency with which to buy more US goods. So, US industries prosper.

On the other hand, there are disadvantages. While the lending country might have lowered its interest rate to stimulate exports, the borrowing country might have raised its interest rate to attract money in the hope of revitalizing their failing economy. In this situation, the lending country has not only exported their money, but their industry and jobs. And the borrowing country is building on debt. At some point in the future, the revitalization must become enough to pay down the debt.

To understand the carry trade on the global scale, I’ll use Japan as the Carry Trade strategy. The strategy basically started there and Japan has been revolving around the consequences for nearly 20 years. Tell me if you can find the advantages reaped by Japan when they become the Carry Trade of choice. Then tell me if the opposing countries, especially in Asia, found their “revitalization” efforts worth the debt they took on.

Japan and the Carry Trade.

The carry trade strategy began in the 1980s when investors borrowed the yen and loaned it elsewhere. Japanese industry prospered and they invested their profits in other countries. This fell apart in 1993 after the Japanese bubble collapsed. then Japanese investors brought their money home and the yen appreciated.

The second round of carry trade began in the summer of 1995 and ended in late 1998. Now,the yen carry trade is built on the policy of the Japanese government to keep its interest rate and currency weak to export its way out of recession and deflation. This crash was caused by the failure of loans to sub-prime mortgages and the subsequent worldwide devastation on the markets.

Now, with the yen at 15 year highs relative to the USD, Japan has “intervened” in the currency market to try and depreciate its yen relative to the USD. They want to sustain their position as the borrowing currency of choice in order to boost their export market. It last did this in 2004. They do this by buying dollars and selling yen.

The good news:

Japan’s intervention against yen strength for the first time in six years means even more liquidity for already flush global markets, paving the way for further gains in higher-yielding currencies against the yen.

The bad news:

Now that the Bank of Japan has committed itself to weakening Yen through intervention, the question is – will it work? So far, [in] the headlines, many economists and analysts are very skeptical of the outcome of this action. The prevailing opinion is that effort will be fruitless and the Yen will be making new highs again. Number of reasons is quoted including the recent failed intervention by the Swiss National Bank. In addition, everybody seems to be of opinion that the currency market is too big to tackle, even for a central bank. According to the Bank for International Settlements, daily trading volume in USD-JPY, which is the target of intervention, is about $560 billion. Eventually, money will once again flow into the Yen.
[Will the intervention work? |]

Tokyo lashed out after it was revealed that China had upped its buying of JGB, in an attempt to further prop up the yen, completely counter to their own interest. Conversely, the BoJ’s easing move, was a direct attempt to make the country’s exports more competitive with the Chinese. We’ll see how much this continues to play out in the foreign exchange market, as both countries attempt to weaken the others’ exporters.

Then there is the “safe haven” aspect of the yen. However, Japan’s debt currently stands close to 200% of GDP and is projected to grow to as high as 400%. In addition, based on Purchasing Price Parity (PPP), the Yen is among the most overvalued currencies in the world, by about 25 % in relation to the Dollar.

Also, as an industrial power, Japan’s exports have done well. A lot of money in the world’s stock markets comes from Japanese insurance companies and pension funds. And the cash rich industries find that further investment in Japan is outweighed by the carry trade. They invest in countries with higher rates. However, US stock markets are denominated in US dollars. If the yen rises, that means that a Japanese investment is losing money just to get into and out of the stock – even if the stock is going up in dollars.

Emerging Markets.

Lately the fad has been to use the borrowed money to invest in the very high rates from emerging markets. Other than the US and Japan’s proven industrial strength, the other countries of the world, IMO, could be classified as “emerging markets”. Many have been in world trade for centuries, but their industries are small and economies are new or newly revised from the changes to new regimes. Britain, Germany and China fall into some other bracket.

Here lies a fundamental factor, mention before, of the carry trade: the higher interest rate countries might be borrowing into debt situations beyond their control.

What about the the Kiwi, Aussie, and Loonie? Are they being overshadowed by even more rapid appreciation in emerging market currencies. This shift is largely a product of changes in interest rate differentials, which are now gapingly large between developed countries and developing countries. Compare the 2.75%+ spread between the US and Australia, with the 8.5% spread between the US and Brazil or 12.75% between the US and Russia. Singapore’s rate stands at 24% right now. Are investors becoming complacent about risk again?

Back to Japan and its “carry trade” with Asian “emerging markets”. In the 1997 Asian crisis where the yen was borrowed and loaned to Thai baht (THB). Part of that crisis originated with huge extensions of Japanese credit to these economies and their use of the yen carry trade. When the debt came due the Thai baht went down the tubes and eventually carried the Indonesian rupiah, Philippine peso (PHP) and others with it.

The Thai baht was also in the carry trade against the USD at the time.

Filipino stocks have been feasting on cheap dollars; just borrow the USD, lend the PHP, rinse and repeat. The Philippines actually get a twofer for our policies as the stimulus increases demand for Filipino expatriate workers throughout the region; their remittances are one of the top sources of export earnings for the nation…in Washington are doing an outstanding job of stimulating market speculation in South Asia without doing much for the US economy other than depriving American savers of the opportunity to make a return on cash.
[]US Credit Turbocharging Emerging Asia | Markets |

We see today several major countries struggling to debase their currencies as fast as possible against each other in an attempt to gain benefits in the world carry trade:

The interest rate difference between the two currencies is about 2 percentage points, which encourages cross-border carry trade. China’s decision to make the yuan more flexible against a basket of currencies on June 19 has fanned expectations that the yuan would appreciate gradually against the dollar.

While analysts said the yuan’s value would not change dramatically against the dollar in the short term, it would continue to rise gradually.

“China cannot afford a one-off revaluation of the yuan,” said Li Jianjun, an economist with the Central University of Finance and Economics. “The expected gradual appreciation, however, would lead to continued inflows of speculative capital.”
[Source:China Daily]

The amount of money going into China is enormous. From the point-of-view of the carry trade would this be borrowing? Is China taking on debt like a counter currency for their fantastic industrialization?

South Africa’s central bank will probably cut its key interest rate tomorrow after the inflation rate slid to a four-year low. That’s unlikely to satisfy demands from labor unions and exporters for action to weaken the rand.

The Pretoria-based Reserve Bank will lower the repurchase rate by half a percentage point to 6 percent, the second reduction this year, according to 23 of 26 economists surveyed by Bloomberg. The rest expect the rate to stay unchanged.

Right now the Rand is trading at just below the dollar. In other words it’s getting stronger and stronger, which negatively impacts exporters and positively importers.

The rand’s 30 percent rally against the dollar since the start of 2009 has undermined exports, forcing manufacturers such as Good Hope Textile Corp. to fire workers in a country where one in four have no job. Labor unions and the Organization for Economic Cooperation and Development have called on the central bank to weaken the rand.
[Bloomberg By Nasreen Seria]

The Unwind

The bottom line: it’s all about risk appetite vs risk aversion. In hard or uncertain times, risk aversion can mean a reversal of carry trades. If volume slackens it potentially leads to higher market volatility and the carry trade unwinds. The Carry Trade, which is down 5.9% year-to-date, means the long currency must either appreciate or remain constant. So, when volatility is high – as it has been over the last 2-3 years – trading on this strategy alone can add up to be a loser.

[The unwind starts when t]he carry trade pushes asset prices to unsustainably high levels when the global economy is expanding. But rapid and unexpected changes in the financial environment can result in the virtuous circle quickly turning into a vicious one. In 2008, global financial markets suffered record declines after being hit by a deadly combination of slowing economic growth, an unprecedented credit crisis and a near-total collapse of consumer and investor confidence.

Large-scale unwinding of the carry trade can also result in plunging asset prices, especially under tight credit conditions, as speculators resort to panic liquidation and rush to get out of trading positions at any price. Numerous hedge funds and trading houses had to contend with huge losses in the aftermath of the unwinding of the yen carry trade.

Banks may also be affected if their borrowers are unable to repay their loans in full. But as the events of 2008 proved, the broad decline in asset prices had a much larger impact on their balance sheets. In 2008, financial institutions around the world recorded close to $1 trillion in charge-offs and write-downs related to U.S. mortgage assets.

The global economy was also severely affected, as the collapse in asset prices affected consumer confidence and business sentiment, and exacerbated an economic slowdown. Nations whose currencies were heavily involved in the carry trade (such as Japan) would also face economic headwinds, as an unusually strong domestic currency can render exports uncompetitive.
[]Carry Trade Casualties | Forex

The Japanese Yen has seen the unwinding of the carry trade, which has held up the yen since the 80s. The Yen is now stronger against all currency majors and their exporters are suffering from a strong domestic currency and contracting GDP which is down an annualised 12.7%. Then there is 20 years of QE debt…

The yen carry trade is the major reason why capital markets throughout the world are up in September, especially with 89% of all trades are from professionals, while the lowly retail investor is lost in the sauce. Stocksmirf estimates that there are several hundred billion dollars of outstanding positions in the carry trade, with more being added in the last three days — a level unprecedented. Moreover, when the positions are reversed it would affect every single instrument imaginable and reduce liquidity to zero. … So, what is the yen carry trade? Put simply, it is borrowing at low interest rates in yen and using the loan to buy higher yielding assets elsewhere. During the past decade, the trade has become a “staple” for big time investors. Perhaps the most popular form of the strategy exploits the gap between US and Japanese yields. Anyone borrowing for next to nothing in yen and putting the money into US Treasuries (US government bonds) has received a double pay-off: from an interest rate difference of more than three percentage points and from the dollar’s rise against the yen. Investors make their profit when they reverse the trade and pay back the yen loan. However, monetary authorities throughout the world are now midway through a process of normalising interest rates…


When I studied Inter-market analysis, I noticed how John Murphy used Japan’s historical position during carry trade crisis as the turning points of major economic changes and disconnections from long standing correlations.

The above was before the global financial crisis of ’08. Today there is a new low-yielding currency in town, the USD.

For years, the yen was the currency of choice to fund international Carry Trades. Analysts say negligible US interest rates, [and] its quantitative easing measures…the country is set to withdraw from its ultra-lose monetary policy anytime soon leaves it in a similar position to Japan at the start of the decade.
[Financial Times ]

One thing that concerns me is a repeat of quasi bubble peaking behavior in general commodities – as well as gold in my view, as the USD also shows a bit of weakness after a year long rally to the low 80’s on the USDX. Also of a bit of quandary is the Yuan’s strength, and a bit of competitive currency devaluation amidst the other major currencies, with the Yen peaking a bit and foreboding a further unwind of the Yen carry trade?

Or for that matter aside from the immense size of the USD around the world, what about positing the question of a USD carry trade unwind? Perhaps just before or during any new credit sovereign bond flap in the EU again? How much could the USD rally then?
[Christopher Laird]

This brings up another major component of relative value in the carry trade – confidence.


Governments and corporations around the globe own the U.S. dollar. We have never defaulted on our debt, and, by some measures, there is almost no likelihood we ever will. U.S. dollars held by foreign sovereign funds are invested in dollar denominated securities, overwhelmingly U.S. Treasury notes and bonds. And those numbers are continuing to grow. Foreign entities currently own almost $4 trillion of the total federal debt of $12 trillion. China alone is now holding more than $900 billion.

When stocks and commodities go lower and the USD and Yen higher carry trades are unwound. The expansion of monetary policy from around the globe will not improve confidence if people are without jobs. It seems this excess liquidity is not doing as intended, as money is making its way to developing economies who may be experiencing inflationary forces as the rest of the world deflates.

The Federal Reserve is likely to keep US interest rates at record lows well into next year, enabling global investors to borrow dollars for a song and invest in higher-yielding assets in countries such as Australia and South Africa. The dollar is increasingly being used to fund the carry trade, as foreign-exchange market volatility goes down and risk appetite goes up. This risk appetite comes from QE and intervention – not fundamental changes.

From Elmer T. Peterson in the The Daily Oklahoman (12/9/1951)

“A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury. After that, the majority always votes for the candidate promising the most benefits with the result the democracy collapses because of the loose fiscal policy ensuing…”

Carry Trade Examples in Other Markets

The gold carry trade works as follows. A central bank loans a bank (sometimes called a bullion bank) some gold. The gold lease rate is usually very low. The bullion bank immediately sells the gold and invests in securities with a higher rate of return, such as government long-term bonds. The carry return is the return on the bonds minus the gold lease rate. However, this trade is risky on two dimensions. First, if the bullion bank invested in long-term bonds and the interest rate goes up, the trade could be unprofitable. More seriously, the bullion bank has effectively sold the gold short. If the loan is called by the Central bank and if gold has risen in value, the bullion bank will have to go into the market and purchase higher priced gold. Indeed, if many banks are short, the unwinding of the gold carry trade could drive the gold price even higher.
[]Gold Carry Trade] financial definition of Gold Carry Trade]. Gold Carry Trade] finance term by the Free Online Dictionary.

Here’s a great IFT thread about the gold trade.

Oil futures are showing large contango spreads in the November and December contracts. November and December futures are trading 2.3% and 4.4% respectively, above front month prices. That is a carry trader paradise, especially if you are bearish on oil or on the economy in general. Small investors using the oil ETF`s also benefit from this contango that will be reflected in the ETF`s price when they start rolling over their contracts.

Dividend stocks are all the rage among investors. Yet while their unique combination of potential future growth and attractive current income justifies investors’ interest in them, they’re not bulletproof — and using risky investing strategies to try to take advantage of high dividend yields can come back to bite you.

The carry trade at work…Right now, dividend-seeking investors find themselves in a situation many have never faced before. Interest rates on bonds and other fixed-income investments are at historic lows. Many dividend-paying stocks, on the other hand, are mired in the stock market’s malaise. The combination of depressed stock values and the rising dividends that many companies have paid out in recent months has led to impressively high yields for those stocks — yields that greatly exceed what you can earn from other investments.

In fact, the disparity is so wide that I’ve started to see a new strategy thrown around. It’s a variation on what’s known as a carry trade, where you borrow money at low rates in order to buy investments that are paying a higher rate. In a nutshell, here’s how it works: Go to your broker and take out a margin loan. Use the money to invest in high-yield dividend stocks. With some brokers offering margin loan rates below 2%, you can pocket some nice profits just based on the dividend income you receive every quarter. And if some of those great values among dividend payers see their share prices recover to more reasonable levels, then the capital gains you could earn are just icing on the cake.
[By Dan Caplinger]

[In Ireland t]he bond market is betting that the Irish authorities, in cahoots with their friends in the ECB…will continue to backstop Irish bonds irrespective of how much damage the policies are doing to the Irish economy. …Over the past few months it has become obvious that the financial markets see the world in a totally different light to the ECB and the Government….the financial markets are not rewarding austerity… In fact, the markets are doing the opposite. The more we cut, the higher the interest rate. And the bond market is being kept open by the fact that the markets see Ireland as a “carry trade” which will be guaranteed by the ECB.
[]High bond rates will leave us an economic wasteland | David McWilliams