Borrowing money at low interest rates to fund higher-yielding loans has been the conventional source of revenue for banks for as long as credit currency carry trades, whereby hedge funds, asset managers, or individuals borrow funds in low-yielding currencies (funding currencies) to convert and deposit the proceeds in bonds or certificates of deposit in higher yielding currencies, aiming to reap the return from the interest rate differential. An extra return can be obtained during the appreciation of the high-yielding currency, while in other cases the currency depreciation is greater than the interest rate differential, making the carry trade a losing investment. The two components on which carry trades rest are therefore currency- and yield-related.
Carry trades are also used in bond investing within the same currency by borrowing (selling) bonds at short-term interest rates to finance the purchase of long-term bonds at higher rates. The difference between the coupon received from the higher-yielding bond and the interest cost paid on the shorter-term bond is called the carry return. The downside risk entails an unexpected decline in the price of long-term bonds (and rising long-term interest rates), and a rise in the price of short-term bonds (falling short-term rates). As investors unwind these positions (i.e., sell their holdings of long-term bonds and repay their short-term borrowing), they accelerate the decline in the price of long-term bonds, exacerbating the rise in their yield and triggering the opposite reaction in the price and rates of short-term bonds.
Let’s return to carry trades in currencies. Suppose an investor borrows 100,000 yen from a Japanese bank at 0.70 percent interest and deposits the proceeds in a U.S. dollar–denominated 10-year government bond worth $1,000, paying 5 percent interest. The investor stands to make 4.3 percent from the interest differential plus or minus the exchange rate risk. If the U.S. dollar appreciates by 5 percent over the duration of the investment, the investor makes 9.3 percent (4.3 percent yield differential plus 5 percent currency gain). If the dollar loses 5 percent against the yen, the investment nets a loss of 1.3 percent (4.3 percent yield differential minus 5 percent currency loss).
This example illustrates that currency carry trades have interest rate and currency elements. While higher interest rate differentials play a major role in spurring interest in carry trades, the potential for currency appreciation or depreciation is also essential in sustaining the viability of the trade.
Such a straightforward investment endeavor is the basis of hundreds of billions of dollars worth of daily carry trades by foreign exchange dealers, proprietary traders, and hedge fund managers. As these players aim at reaping the gains from the interest rate differential, they tend to leverage their positions to magnify their returns from what appears to be an assured investment. Accumulating over $2.3 trillion in daily turnover, currency markets thrive on trading volumes among bank dealers, corporate treasuries, and speculators. As participants increasingly exploit emerging opportunities of widening interest rate differentials, volumes expand and momentum intensifies, resulting in self-reinforcing trends, whereby high-yielding currencies rally against their lower-yielding counterparts. The result could entail prolonged trends lasting for several weeks and months.
Every Trend Has Its End
But every trend reaches an end, at least a temporary one. Carry trades are notably visible once they start to unwind. As funds exit high-yielding currencies back into the low-yielding currencies, the latter tend to appreciate in value relative to the former. Such unwinding takes place upon the following:
- Anticipation of a decline in the high-yielding currency or an actual decline in its value.
- Anticipation of a rise in the low-yielding currency or an actual rise in its value.
- Anticipation of a decrease in interest rates of the high-yielding currency, or the end of its tightening cycle.
- Anticipation of an increase in interest rates of the low-yielding currency, or the end of its easing cycle.
- A sudden decrease in risk appetite, which normally leads to a decrease in the high-yielding currency and an increase in the lower-yielding currencies.
The above scenarios may result from new economic data, speeches or reports from central banks, or, in the case of the fourth scenario, a reduction in market confidence, eroding risk appetite due to market declines or geopolitical events. Recall that the profitability of carry trades is reinforced by the buildup of positions, which accelerates the strengthening of higher-yielding currencies and deepens the declines in the lower-yielding ones (funding currencies). Conversely, the unwinding of carry trades can be accelerated by the execution of multiple margin calls and the subsequent opening of new positions, triggering further selling in high-yielding currencies. What may be a 3 percent or 5 percent differential in interest rates between two currencies can be completely eroded during a 6 percent slide (rally) in the high- (low-) yielding currency.