The Return Of The Forex Carry Trade?
The 'carry trade' might be considered among the most famous forex trading strategies and up until around 2007 was very widely used. The advent of the financial crisis from later that year changed the dynamics of that trade making it unviable as volatility intensified and many countries slashed interest rates to historically low levels. The favoured candidate for funding carry trades was the JPY due to years of rock bottom interest rates.
However, there has been some speculation in the financial community that the carry trade might be making a comeback involving JPY to fund holdings in emerging market currencies such as the Turkish Lira (TRY). Japan looks set for more quantitative easing and the JPY has been on the slide for some months, once again making it an ideal funding currency.
The principle behind the carry trade is very simple and involves simultaneously selling a currency with a low interest rate and buying one with a high rate of interest and then pocketing the difference between the two rates. With leverage this can be a very profitable strategy.
From NICE to VUCA
During what the Bank of England governor Mervyn King termed as the NICE (Non-Inflationary Consistently Expansionary) decade, this strategy worked well as currencies and the world's financial system were relatively stable. But from late 2007 the world changed and entered a new normal characterised by what the CEO of Unilever, Paul Polman called a VUCA (volatility, uncertainty, complexity and ambiguity ) environment.
Prior to 2008 among the favoured currencies on the receiving end of the JPY funds was AUD and NZD as both typically carried high rates of interest. However, recently they have been reducing rates making them less attractive and further rate cuts are anticipated for AUD.
For the carry trade, the emphasis has turned to emerging market currencies such as the TRY, where a rate of over 9% can be obtained versus paying 0.55% for borrowing JPY. Click here for a list of MahiFX rates. These days the Turkish economy looks in more robust shape and has better prospects than most western economies. Various Latin American currencies have also been cited as candidates for the carry trade.
More volatility likely
However, it seems unlikely that the carry trade will make a pre-crisis comeback. Volatility inducing events such as the US fiscal cliff, the ongoing Eurozone crisis and concerns over the global economy should ensure that regular bouts of volatility cascade through the markets. Also, when the markets are in a 'risk on mode' currencies such as JPY tend to become safe havens, whilst emerging market currencies are seen as being closely associated with risk assets and get sold off. This can lead to big losses for those engaged in carry trades.
But during brief periods of lower volatility traders may well be tempted to put on carry trades. Generally in the run up to Christmas markets tend to calm down as policy makers and the big financial players go into holiday mode and there's less volume and news to drive markets.