Looking into the future of the popular carry trade

One of the questions that come up often is about the carry trade – what is it and whether it still creates a good magical return for investors as it has always done in its glorious past.

In fact, the carry trade still does exist and is evolving according to the current economic context. Thus it would be a good idea to talk about the popular carry trade so that we can understand how it works and how it can be applied in our current market environment.

Let’s begin with the common form of carry trade. The most straightforward case is borrowing at a low interest rate and investing in an asset that yields a higher rate.

Let’s say you borrow money at an interest rate of 1.5 per cent and invest it in an instrument that gives a return of more than 1.5 per cent with the same size, credit rating and maturity. This carry trade would earn you extra money without you having to move a muscle.

The most popular strategy was the Japanese yen carry trade. It consisted of borrowing yen in Japan, with the interest rate close to zero, and selling the yen to invest in higher-yielding assets such as US Treasury notes or European bonds, which yielded as much as 4.5 per cent, or even more.

In 2007, it was estimated that the outstanding yen carry trade was as huge as US$1 trillion.

As easy as it looks, a seasoned trader would not take this for granted, as there is always a trade-off between risk and return. Carry trades do pose an interest-rate risk, from both Japanese and US rates, and a spot forex risk. An unfavourable fluctuation in any of those factors could easily wipe out the return and even result in a loss.

Investors learned this very lesson in 2007, when the US Federal Reserve started slashing its Fed

funds rate in September. As Japanese interest rates remained unchanged, the yen strengthened sharply from 120 per dollar to below 80 at the end of the cycle.

As a result, traders received a smaller return from the decreasing dollar interest rate while facing the difficulty of using the deteriorating dollar to pay back the loans in yen.

Most had to unwind their position overnight to limit their losses, selling dollars and buying yen to pay back the debt.

That panic strengthened the yen even further and triggered a global sell-off in dollar assets that had been financed by the yen carry trade.

So what happened after that?

Traders are risk takers. We came up with an adapted version of the carry trade, called “covered interest arbitrage”. It is simply a carry trade with a pre-determined FX rate, to limit the risk from exchange-rate fluctuations.

Since 2009, the US key interest rate has gone down to almost zero. The investment started with borrowing in US dollars and promising to return the dollars later, converting them to some higher-yielding currencies, and simultaneously selling the FX forward to lock in the future exchange rate.

The good part of the strategy is lower risk. The bad part is that returns also become lower because there is a cost to lock in the future exchange rate. The return of the new version of carry trades is no longer as exciting as it once was.

Another change was that investors shifted their interest from the yen to the miracle Asian story, led by China, with high interest rates not only from the amazing growth story but also from high inflation.

However, history again repeated itself. The dollar carry trade again came to its end.

The current situation of the US expected to start raising its benchmark interest rate along with signs of an Asian slowdown would surely make you think twice about jumping into the legendary carry-trade strategy.

The dollar’s gain against a basket of major currencies of almost 12 per cent since last year is the best signal to jump ship. What then is the future of the carry trade? Will we soon experience its extinction, or another evolution?

The US will tighten its monetary policy further by increasing its interest rate for at least a couple more years while its economy is on the verge of recovering next year. Asia’s emerging-market growth will slow down slightly because of China’s weaker economy.

As a result, it will be hard to see the same old dollar-carry-trade strategy for a while.

Could it be a reverse carry trade? Perhaps .........

Jitipol Puksamatanan is a capital-market economist at TMB Analytics, the economic analysis unit of TMB Bank, and can be reached at [email protected].