What is the Carry trade and how can I Profit from It?
The primary goal of every professional fund manager is to make their clients money, and making money comes down to one thing—yield. Traders and investors are primarily interested in finding yield. One common way that fund managers position their portfolios in order to earn yield for their clients is to engage in what is termed “the carry trade” with their forex broker. In this article, we will break down the basics of the carry trade, what it is, and how traders can profit in the Forex Market by understanding this dynamic investment vehicle.
In order to understand the basics of the carry trade, one must first have a basic understanding of yield in the FX Market. Each currency pair has a short-term interest rate that its country’s Central Bank sets every two months. For example, in the United States of America, the Federal Reserve sets the short-term interest for the U.S. Dollar every two months. Their decision of where to set this interest rate is a rather complicated process, but in short, they set the interest at a level which will best support economic growth. This short-term interest rate has a ripple effect throughout the economy and everything from mortgage rates to car loans to government bonds are affected by this interest rate.
The carry trade involves borrowing money in a low-yielding currency, and then putting that money to work in a higher yielding currency. The trader pockets the yield differential between the two currencies, and also tends to benefit from currency value appreciation as higher yielding currencies tend to appreciate over time. Next, we will identify which currencies are considered low-yielding and which are considered higher-yielding, and then we will walk through an actual carry trade example.
Currently, the lowest yielding currencies among developed nations are the U.S. Dollar, Japanese Yen, and Swiss Franc. The Japanese Yen has held extremely low interest rates for over a decade, while the U.S. Dollar and Swiss Franc have held low rates since the break of the 2008 Credit Crisis.
Currently, the British Pound, Euro, and Canadian Dollar are considered medium-yielding currencies. Similar to the U.S. and Switzerland, each of these currencies experienced a dramatic decrease of interest rates as the Crisis of 2008 began to unfold; however, none of these currencies was lowered to the extent that the Dollar, Yen, and Franc were lowered.
The Aussie Dollar and New Zeland Kiwi are the two currencies among developed nations that are considered high-yielding. These currencies offered interest rates in excess of 7% before the financial meltdown of 2008. As the crisis unfolded and Central Banks began to slash rates in order to ward of a complete financial collapse, Australia and New Zeland were still able to keep rates above other developed nations.
How does the Carry Trade Work?
An investor borrows millions of dollars in the Japanese Yen because the interest rates are barely above 0%. Now the investor takes that money and invests in a currency such as the Aussie Dollar where it can earn yield of, say, 5%; consequently, the investor has borrowed money at near 0% and is now earning 5%. That’s an easy way to make money! Now couple this with the fact that, as a general rule of thumb, currencies with a higher interest rate tend to appreciate over time. Thus, the investor not only pockets profits through the yield differential between the Japanese Yen and Aussie Dollar, but it also potentially pockets thousands of pips over the course of a year as the AUD/JPY appreciates over time. This is how investors play the carry trade.
When Does It All Go Horribly Wrong?
Although the general norm is that currencies with a high yield do appreciate over time, there are moments in financial markets when a high yielding currency can suffer precipitous declines. For example, when the Crisis of 2008 erupted, the carry trade fell completely apart. As fear gripped the global financial community, traders and investors wanted to liquidate all of their risky investments and get into cash. To do this, they had to repay all the loans they took out in Japanese Yen. In order to repay the loans, they had to sell all of their Aussie Dollars and convert them back into Japanese Yen. This causes a massive sell-off of high yielding currencies and a massive amount of capital flow into low-yielding currencies, such as the Japanese Yen and U.S. Dollar.
Understanding the carry trade can help a small cap trader profit in the FX Market. If the economy is rebounding and growing, a trader will not want to be buying the Japanese Yen because many large traders will be selling it as they borrow in the Yen in order to invest in higher yielding currencies. Being aware of how this dynamic works in the FX Market can offer a further edge to traders.