Whither the Carry Trade?

♠ Posted by Emmanuel in at 3/03/2007 01:18:00 AM
The recent worldwide stock market crash has been blamed on, among other things, the unwinding of the carry trade. The Federal Reserve Bank of San Francisco (FRBSF) describes the carry trade thusly:
In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the "funding" currency), converts the funds into a high-interest-rate currency (the "target" currency) and lends the resulting amount in the target currency at the higher interest rate.
Though there are debates on the exact mechanics of how carry trades are conducted and on the volume of existing carry trades, the underlying concept is simple. Look at this table depicting various official overnight interest rates for various world currencies. A very popular carry trade pairing, at least until very recently, has been to borrow in Japanese yen (yielding 0.50%) and to lend in New Zealand dollars or "kiwi" (yielding 7.25%). Assuming the kiwi/yen exchange rate (NZD/JPY) does not move too unfavorably against the kiwi, then you can pocket significant gains by entering these carry trades. If the exchange rate remains steady from the time when the carry trade is written to maturity, for instance, then you pick up 7.25%-0.50%=6.75% in interest rate gains. From about September 2006 to a week ago (see chart below), the carry trade seemed a good trade to pursue for the NZD/JPY exchange rate largely moved in favor of the kiwi. Not only did you gain from the interest rate differential, but you also gained from the kiwi becoming dearer against the yen. In the parlance of finance, there is a condition called "interest rate parity" where gains from interest (6.75% here) should be offset by equivalent exchange rate losses. Like many financial theories, however, this condition does not often hold in reality. The opposite happened as more traders boosted the kiwi and other high-yielding currencies at the expense of the yen by piling into the carry trade (click for a larger image):

Then the Shanghai crash roiled global financial markets. When global equity market sell-offs occur, what typically happens is that investors become more cautious; riskier assets are traded for safer ones. Since the carry trade was aided by a lot of leverage--or borrowing--it was ripe for a turnaround. The looooong (red) drop in the fourth indicator from the end is that on February 27. The yellow line at the bottom of the chart represents the relative strength index (RSI), where overbought/oversold levels are at 70% and 30%, respectively. As you can see, the NZD/JPY went from a nearly overbought to an oversold condition in the span of a mere four days! The unwinding of carry trades like this one has been rapid in the aftermath of Shanghai's drop as those who undertook these trades have been forced to cover their losses by buying back yen and Swiss francs--another favorite funding currency.

The political economy aspect comes in who benefits and loses from a yen that has been kept weak by all this carry trading. Unsurprisingly, US Treasury Secretary Henry Paulson, formerly chairman of the American investment bank Goldman Sachs, has been uncritical of the carry trade as Wall Street benefits from easy money conditions arising from the carry trade. The Japanese have adopted an attitude of "benign neglect"; though they recently raised their overnight rate from 0.25% to 0.50%, this rate remains comparatively low. Of course, their exports benefit from lower prices abroad as a result of the weak yen. On the other hand, the EU has been warning about the dangers of the carry trade for some time. In part, their cautious stance may be attributable to having the euro bear the brunt of the dollar's recent weakness, making European exports costlier than their Japanese counterparts. Nevertheless, Jean-Claude Tritchet and company appear to have been vindicated by recent events. The carry trade has little to do with "market forces" in operation and a lot with rampant speculation. Hopefully, it will fade away.