Article / 06 September 2016 at 9:00 GMT

The FX carry trade lives – for now

Head of FX Strategy / Saxo Bank
  • Carry trade strategy a phenomenon of optimistic markets
  • AUDJPY carry trade breakdown demonstrates limits of technique
  • Market signals show that the post-crisis USD carry trade has returned
  • Belief that Fed can't normalise policy creating a 'bubble-like' circumstance

Federal Reserve
The Fed's reluctance to hike rates is leading to a 'bubble-like' scenario in markets where investors doubt its capacity to meaningfully normalise policy. Photo: iStock

By John J Hardy

The FX carry trade is a time-honoured method investors have used, in favourable circumstances at least, to mint money from the currency market. The basic idea of the carry trade is simple: a carry trader borrows funds in a low-yielding currency and then invests, often with leverage, in a higher-yielding currency. 

In theory, the trade shouldn’t work, as inflation is usually higher in a higher-yielding currency, meaning that over time, that currency should devalue relative to the lower-yielding (and lower-inflation) country over time. 

But for remarkably sustained periods, the carry trade can and does work, largely due to the power of capital flows from investors. It works much like a Ponzi scheme – as long as a constantly growing flow of funds is engaging in the trade, the returns accruing to the participants continue to grow. 

The great AUDJPY carry trade
To illustrate, consider the great Japanese yen carry trade of about 2002 until it began breaking apart in 2007. Japanese investors in particular, dissatisfied with domestic interest rates near zero and weak growth, looked abroad for higher returns on their enormous piles of savings. With a booming global economy fed by easy credit, better growth stories weren’t hard to find and they invested in places like Australia, where a surge in commodity prices on insatiable demand from China sent growth surging. 

Inbound investment into Australia sent growth surging and the Reserve Bank of Australia responded by hiking interest rates to cool demand. The higher rates ironically also fed a growing demand for bigger and bigger inflows and the stronger currency from all of the inflows, meanwhile, kept inflation down, so the currency not only retained its purchasing power but also increased it. 

AUD versus JPY carry traders earned not only on the strengthening currency itself, but on the higher interest paid in Australia. An aggressive investor at the time could earn returns of several hundred percent in long Australian dollar/short Japanese yen with the use of leverage over a few short years.
Of course, as indicated above, the trade only works under the "greater fool" theory of investing, and once the flows stopped with the arrival of the global financial crisis, the end was swift and brutal. Overleveraged players still involved in the trade lost everything.

The post-crisis USD carry trade
Then, in the wake of the global financial crisis, a powerful new US dollar carry trade developed, most notably in emerging market economies from Brazil and Turkey to South Africa and Mexico, where corporations in particular took advantage of the US Federal Reserve’s very easy monetary policy to borrow trillions of dollars to fund domestic operations. 

This trade came to a halt in late 2011 and reversed, if less spectacularly than the 2008 experience.
Since early 2016, however, there are signs that the US dollar carry trade has returned with a vengeance, driven by the idea that the Fed can never really normalise rates again and will keep policy extremely loose until inflation rises. Tantalisingly, some recent Fed rhetoric even suggests that the Fed’s inflation target should be higher to make up for the lack of nominal growth. 

'The worse, the better'

Suddenly, the worries about the trillions of USD that still need to be repaid by emerging market actors have been abandoned and global investors, once again chasing higher returns in a low-return world, are scouring every corner of the globe – the riskier the currency and worse the economy, the higher the returns. 

Take the Brazilian real, which, including interest, has vaulted some 30% against the US dollar since the January lows this year. The Russian rouble is up a similar amount. For its part, the Fed does seem to have a dim awareness of the risks of pursuing overly easy policy as at least two Federal Open Market Committee speakers have mentioned financial stability as a factor, though they are inevitably focused on domestic lending practices and asset markets than global risks. 

Does the USDBRL decline represent a real expansion of the Brazilian economy? Photo: iStock 
The Fed has been called a serial asset bubble blowing machine by its critics. This latest episode in global currencies and asset markets is taking on bubble-like proportions amidst the belief that the Fed is permanently sidelined from pushing against asset markets because of tepid US inflation and growth.

If the Fed doesn’t hike at the September 21 FOMC meeting, it will appear even more tone-deaf to the risks it is inflating globally than ever.

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank

Juhani Huopainen Juhani Huopainen
One currency carry trade-ETF and world stock market ETF. Hand-in-hand, most of the time.
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