By Kathy Lien, Director of Currency Research, GFT
If you have spent more than one month in the foreign exchange market, you have probably encountered the term “carry trade.” A carry trade simply involves buying a currency with a high interest rate and funding it with a currency pair that has a lower interest rate. This type of trade was extremely popular between 2003 and 2007 for individual traders as well as the largest institutions in the world.
At the time, the carry trade appeared to be an easy “one-way trade” that offered not only a healthy interest rate that could be earned every day, but also capital appreciation. What goes up eventually comes down and the go-go days of the carry trade came to a screeching halt in 2008 when the global financial crisis caused a wave of massive deleveraging that erased all of the gains made in the past four years and then some.
However, since the beginning of 2009, the carry trade has shown new life with some currency pairs rising more than 45 per cent from their lows. This had led some traders to wonder if the carry trade is finally coming back from the dead.
Over the past few years, buying the Australian dollar and selling the Japanese Yen has been one of the most popular carry trades. To implement this, a trader would go long AUD/JPY in the hopes of earning daily rollover and capital appreciation.
In 2003 for example, AUD/JPY rose 36 per cent and during that year Australian interest rates were at 4.75 per cent while Japanese interest rates were at 0.25 per cent, creating a differential of 4.50 per cent. A foreign exchange trader who went long AUD/JPY in the beginning of the year and used no leverage, would have made approximately 36 per cent in capital appreciation and 4.50 per cent in interest income by the end of the year.
On 10 to 1 leverage, the gains were much more substantial. Even in a year like 2006 when AUD/JPY only appreciated 6 per cent, on a leveraged basis, the gains were impressive. As long as AUD/JPY did not fall, carry traders made money.
But good things always come to an end and carry trades fell voraciously in 2008. Carry trades became unprofitable when the currency pair falls by more than the interest income.
In 2008, the Australian dollar offered an average interest rate of 6.4 per cent while the Japanese Yen yielded approximately 0.4 per cent, creating an interest rate differential of 6 per cent. That same year, AUD/JPY fell 27 per cent, creating a net loss of 21 per cent. For a trader using 10 to 1 leverage, the losses were crippling. So the biggest risk for carry trades is the realistic possibility of the currency pair falling in value just as it did in 2008.
However in 2009, aggressive monetary and fiscal stimulus by central banks around the world helped to stabilize the financial markets.
Even though interest rates around the world converged towards zero, currency pairs such as AUD/JPY recovered dramatically. This caused some traders to wonder whether the go-go days of carry trades has returned. The primary goal of a carry trade is to earn interest income. With six of eight major central banks offering interest of 1 per cent or less, the potential income is next to nothing. Currency pairs such as AUD/JPY and AUD/USD offer relatively attractive rates, but a recovery in the Australian dollar is not the same as a recovery for all carry trades.
In addition to the Aussie, going long the New Zealand dollar, Canadian dollar and British pound against the Japanese Yen and U.S. dollars were also popular carry trades.
In order for carry trades to really recover, three conditions need to be satisfied. First volatility needs to come down. Secondly, the majority of global investors need to start believing that the recovery is here to stay and that we will not see a double dip recession. Finally, central banks need to start talking about raising interest rates. Since the beginning of the year, volatility has fallen and central banks are beginning to mull exit strategies but we aren’t there yet.
Other articles in this week’s newsletter