Substantial gains made from interest rate differentials provide undeniable evidence that the carry trade strategy has been very successful over the past few years. Previously, a trading strategy done exclusively by large investments banks and international companies, the carry trade has only become popular among individual traders over the past few years thanks to the availability of leverage.
The current market environment with implied volatilities at historical lows continues to favor carry trades, but trends like this cannot last forever and it seems that a number of factors are working to erode the consistency of the carry, raising the risks of a carry trade unwind in 2007. Interest rate spreads are changing, central banks have been very vocal and diversifying their reserves while contrarian money is moving against the carry flow. Of some concern is the recent exaggeration of short positioning in both yen and Swiss franc futures contracts with the difference between speculative and commercial positioning close to the largest on record.
Carry Trade Overview
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Money shifts from around the world in seek of the highest yield and the benefit of trading currencies is that you are dealing with countries that have interest rates, which are charged or received every single day. If you are positioned on the side of positive carry, you have the right to earn that interest, which can be quite lucrative over time.
The EUR/USD chart below is a perfect example of carry. From 2001 to 2005, the indicator at the bottom of the chart shows that interest rates were higher in the Eurozone than in the US. This positive differential helped the pair to gain 5300 pips from 0.82 to 1.35 over just four years time. The opposite scenario occurred when we had both negative and expanding differentials. In fact, from 1999 to 2001 negative interest rate differentials pressed the EUR/USD lower from 1.25 to 0.82, a gigantic loss of 4300 pips in just two years. Once positive or negative interest rates differentials start contracting or approach parity, trending markets usually end which favors a return to range bound trading.
The Benefits of Carry
Carry or interest rates can make a very big difference when it comes to account equity as it could easily allow for over 5 percent annual returns. When factoring common levels of leverage, these gains can be pushed up to as high as 50 percent. Big market participants like banks and hedge funds have taken advantage of the carry trade for a long time and have dealt with the possibility of giving up gains to capital losses by making portfolios of positive carry trades The chart below shows the power of interest on a long carry portfolio held for the past 3 years. Holding a basket of trades dampens the effects of any single currency while still collecting the steady interest income.
Risks to Carry Trades
Carry trading involves significant risks and trades can rapidly unwind without any word of warning. A significant risk for carry trades is that so many investors are piled into the same trades that unwinds can be sharp and brutal. For example, short positions in Japanese yen currency futures traded on the Chicago Mercantile Exchange have been close to historical highs but the latest CFTC commitment of traders report showed that some traders were already washed out with speculative short yen positions reduced to about half of the level seen in October. However, this cannot be taken as an early sign for a massive unwind because different risk profiles among different traders will allow some to stick with the pair for a longer period of time to collect the smaller spreads while others may immediately bail out.
Central banks have also been increasingly vocal about currency fluctuations. Both the Swiss National Bank and the Swiss Finance Minister have expressed dissatisfaction with the weakness of the Swiss Franc with the SNB is even considering raising interest rates in a low volatility environment to encourage more strength in the franc. As for Japan, the Governor of the Bank of Japan has been talking about lifting interest rates again before the years end. On the other side of the equation, nations like Canada, New Zealand and the US have driven their interest rates to such levels that the damaging effects on their local economies have become all too apparent. This sets into motion speculation that rate spreads will contract and returns will dry up. Carry traders know that they are at the rear end of a major profit opportunity and given the inherent risks and diverging fundamentals, they will most likely be ready to flee at the first sign of trouble.
Finally, implied volatilities in foreign exchange are close to a historical low, which is extremely friendly for carry trades but could be the calm before the storm. Implied volatilities are often used to quantify the risk of capital losses in carry trades. On one hand, high volatility can be dangerous for carry trades because the price of the currency pair can change so dramatically over a short time period that the interest gained from the carry trade could not be enough to make up for the losses. On the other hand, low volatility markets are often a trademark of yield chasing behavior meaning that investors are paying little attention to fundamental economics. For example, the long US dollar carry trade (against the yen) is still working at this point given the high US interest rates. Even though most economists believe that significant dollar depreciation needs to occur in order fix the burgeoning US current account deficit,, for the time being, the volatility environment makes it only a minor worry.
The Odds of a Carry Trade Unwind in 2007
With several issues clouding the strength of one of the most lucrative trading strategies, it must be asked whether a violent unwinding of long established carry trades could be underway. Though possible, at this point, it is unlikely. First of all, it is dubious that the benchmark lending rates of the different nations will all be equal. Interest rates are only partially influenced by exchange rates and international trade. In fact, domestic trends are the most influential factors behind monetary policy. It would take a lot for Japan to close its interest rate gap with the US, the UK and even Europe. This means that only under rare conditions would interest rates ever reach parity, and therefore carry trades could still work for the time being, particularly for longer term traders. Another facet to the nature of interest rates is the pace at which the dynamic can change. These national lending rates change infrequently and usually in small quantities. Typically, rates are changed in 25 basis points increments which is the equivalent to a quarter of one percent. Additionally, these changes usually come during predefined meetings that are held sometimes nine times a year for some like the US and four times a year for countries like Switzerland. This gradual pace allows for more than enough time for market participants in for the long-run. Consequently, if a once profitable interest rate spread begins to contract, the capital flows into other potential carries would be slow and orderly. Perhaps the most convincing argument that a dramatic unwinding in carry trades is not on the horizon rests with margin. Smaller traders and hedge funds that attempt to reap the rewards of the carry trade, usually take advantage of leverage in order to multiply their returns. This leaves them incapable of withstanding smaller fluctuations in the exchange rate while they collect the interest, as they will are often margined out. However, hedge funds and individual traders do not account for the bulk of the capital behind carry traders, rather big banks, pension funds and international corporations do and these institutions do not trade on leverage, managing to stay away from margin calls. This suggests that although we could see an unwind, it may not be huge.
