Talking Points:The New Carry Trade
What is the Carry Trade?
What Happens When the Carry Trade Reverses?
The New Carry Trade
Traders are opportunists in the purest sense. Like an entrepreneur in a well-defined industry looks for inefficiencies and gaps in order to fill a need and start a business, a trader looks for patterns and developing trends in order to buy the undervalued and sell the overvalued in hopes of capturing a profit.
Because the FX market is a pairs market, meaning you do not trade one singular product, traders in FX will often look to do both at the same time. This effect is most evidently seen in the Carry Trade.
What is the Carry Trade?The Carry Trade is not specific to the FX market but is very applicable to the FX market due to its purpose. The purpose of the carry trade is to sell a lower yielding currency or investment because the interest you pay to sell the product is very low while simultaneously buying a higher yielding currency or investment because the interest you earn is higher. Carry gets its name for the action of carrying the higher yielding currency while selling the lower yielding currency and earning the spread.
Due to the central bank induced low or negative interest rate market, many carry trades have revolved around borrowing in countries where interest rates were negative, because if you’re going to borrow, who wouldn’t want to earn instead of pay, and use that negative interest rate to find a higher yielding investment.
When times are good and steady or the regime that put a low or negative interest rate in place isn’t challenged, then the Carry Trade may seem like you’ve found a mint that prints money, however, when the Carry Trade unwinds, it’s often one of the most volatile events in markets.
What Happens When the Carry Trade Reverses?The problem with many Carry Trades is that there obvious? In early 2015, the European Central Bank found that much of the debt they had previously issued was now on the market paying a negative interest rate. This was not private information, which means that people from all over the world began to borrow from the European Debt market like the German Bunds via the EUR in search of greener investment pastures. Similarly, the products that attract capital are often similar albeit with more variety to the currency borrowed or sold.
If you think of a distribution or Gaussian curve, there are two tails with a belly in the middle. If you think of the left tail as low or negative interest rate environment and the right tail as the high yielding environment, it can help you visualize where capital comes from and where capital is going. The middle of the curve or belly is other investments that lies somewhere in the middle attracting capital for specific investments or funds that only look to invest in certain sectors or regions such as housing, energy, or Asia-Pac or Emerging Markets. The money that flows to high-yielding investments solely because they are high-yielding investments presents a rare and specific risk.
Carry Trade RiskCapital flow is finicky. However, the most fastidious capital is capital which is in an investment only because of prior gains that other have investors have received from the investment. While a poor analogy, it’s not unlike a Ponzi scheme only in the sense that money coming in helps to sustain the argument that the investment or high-yield play is working. And it works, until it doesn’t. Because the investment was supported by the fact that it was a good investment, when it stops being a good investment, the money leaves. This capital outflow is not unlike someone yelling “fire” in a crowded theater.
All the money rushes out of the high-yielding investment, effectively reversing the trade, so that the safe low-yielding market is bought back and the high-yielder is sold.
Therefore, the Carry Trade risk is in the unwinding of the trade. The carry trade unwinding often have very little warning and are very sharp. The sharp unwinds can leave traders wondering what happened and typically validate the use of a protective stop loss.
