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Currency 'carry trades' continue to be a two-sided coin
by Emily Sanders
October 29, 2009
There are numerous forces at work that
affect world markets. One that bears close examination is the currency "carry trade." In simple
terms, a currency carry trade involves using the currency of one country (the funding currency) to
purchase the currency of another (investment currency). We do this ourselves when we travel,
exchanging our U.S. dollars for the currency of our destination. If the dollar weakens while we are
traveling, then our leftover foreign currency will buy more dollars when we return.
Most carry trades are leveraged, meaning the trader borrows the funding currency before
selling it (a short sale). Low interest rates for the funding currency are key. In most cases, the
lower a country's interest rates, the cheaper it is to borrow that currency. An ideal investment
currency is from a country with high growth and interest rates. In this scenario, the investor
profits two ways: by the interest rate differential and by the investment currency appreciating
relative to the funding currency.
A carry trade as described above can be extremely profitable, but a leveraged carry trade
also can suddenly become unprofitable. Traders caught off guard might be forced to unwind their
position, which would involve buying back the funding currency they had previously sold short. If
several large carry trade positions are forced to unwind at once, the result can be devastating to
world markets and cause a dramatic increase in the price of the funding currency.
For example, the Japanese yen traditionally has been the funding currency of choice for
carry trades. At the height of the bubble years - between 2005 and 2007 - a preferred trade was to
sell the yen and buy the dollar. But investors started getting nervous in mid-2007 and began buying
yen and selling dollars. The timing coincided with the global peak in equities and the dollar sold
off to record levels leading directly to oil prices of $147 per barrel.
In late August 2009, dollar LIBOR rates, which used to calculate dollar-borrowing costs,
fell below yen LIBOR rates, making the dollar cheaper to borrow than the yen. Over the short term,
a falling dollar makes our exports more attractive, stimulates inflation in the economy and boosts
the profits of companies doing business overseas. But dollar weakness is a double-edged sword. The
S&P above its 2007 highs would mean little if it leads us back to expensive fuel costs.
The longer the carry trade continues and U.S. dollars are sold short, the sharper the
reversal will be when unexpected dollar strength forces traders out of their positions.
Unexpectedly strong economic growth, the Fed tightening monetary policy or a major negative
geopolitical event could force the unwinding of dollar short positions and potentially destabilize
world equity markets.
The big question becomes: When will the carry trade reverse? No one can say for sure, but we
know it is possible to take advantage of the move while it lasts. Energy, commodities and
international equities will benefit most directly from a falling dollar.
Carry trades can serve as omens of financial bubbles. This was seen with the yen during
Japan's real estate bubble in 1988, the Asian emerging markets bubble in 1998 and the global
financial bubble in 2007. With the dollar now serving as the funding currency of choice for the
carry trade, bubbles can show up on any corner of the globe. It is not suggested that individual
investors participate in currency carry trades, but by observing them, we can see evidence of macro
forces at work.
Emily Sanders is president and CEO of Norcross-based Sanders Financial Management. She is a
locally and nationally recognized investment advisor who is quoted often in the Atlanta
Journal-Constitution, CNBC, Bloomberg News and CNN Radio.
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