menu

What Are Carry Trades and Why Do They Matter Now

Jami Seitsonen September 13, 2024
Go Back * Topics * 2024 *

Reading about specific trading strategies is usually left for the finance enthusiasts but the term carry trade made it all the way to the mainstream newspapers in August. In this quarter’s Bergos Next Newsletter, we would like to explain what carry trades are and how they contributed to the recent decline in stock prices. We also follow up with other examples and what to keep in mind if you ever find yourself considering a carry trade.

What is a Carry?

Starting from the basics, the first obvious question is: what is carry? Carry is the return an investor obtains from simply holding an asset. The most common sources of those returns are interest rates, coupon payments from bonds or dividends from stocks, excluding the returns from increases in share price. In other words, the return you get if the price does not change. There are also other examples such as the possibility of a negative carry of an asset due to storage costs or because they depreciate over time, these can be commodities like wheat or soybeans. Besides the carry, the investor can gain or lose from a price appreciation of the asset they are holding, for example the currency they are holding can appreciate against another currency or the price of the stock can increase/decrease.

Now, as we have the concept of carry figured out, let us investigate how you could trade it.

What is a Carry Trade?

In a carry trade the investor borrows in a currency with a low-interest rate and invests those funds in a currency or asset with a higher interest rate. The investor then profits from the difference between the interest rates if the price does not move against them, and the carry differential persists. Meaning, a carry trade involves borrowing the asset with a low carry and buying one with a higher carry.

The below examples are the two main risks in a currency carry trade:

  1. Exchange Rate Risk: If the currency in which funds are borrowed appreciates significantly against the currency in which funds are invested, the gains from the interest rate differential could be wiped out by exchange rate losses.
  2. Interest Rate Fluctuations: If the interest rate in the borrowed currency rises or the rate in the invested currency falls, the carry trade may no longer be profitable.

In these circumstances, investors might be forced to close the trade. This means selling the currency/assets which were bought using the borrowed funds and then paying down the loan. On a market-level, this puts pressure on the prices of the assets which investors were buying with borrowed funds while appreciating the borrowed currency/assets. And this negative price movement might force other investors to close their trades as well.

What Happened in August?

Many of the most common carry trades have involved borrowing in the Japanese Yen. The Japanese central bank has kept the interest rates near zero since the mid-1990s and below zero most of the last decade. With this policy, the Bank of Japan hoped to stimulate the stagnating Japanese economy which has suffered from low growth as well as deflationary pressures. Low growth and low interest rates have also contributed to the weakening of the currency. This made the yen an attractive candidate to be the borrowing currency in a carry trade.

The yen trade is nothing new as it has been the preferred borrowing currency for US dollars, New Zealand dollars and Mexican pesos among others for quite some time. However, as the rest of the world started hiking interest rates in 2022 to fight inflation, the Bank of Japan kept their interest rates still low, which made the yen carry trade even more attractive as the investors could now earn over 5% in US dollar money market while paying 0%-0.1% interest on their loan in yen.

However, at the end of July the Bank of Japan raised interest rates to 0.25% and presented a plan to unwind its massive bond buying programme. In the following days, US economic figures showed signs of weakening, most notably the unemployment rate rising to 4.3%. At first this does not sound too drastic, but the market prices in future expectations – in this case investors were negative about the economic outlook. Japan’s return to a more normal monetary policy implies that there will potentially be more interest rate hikes in the future while the weaker US data points towards more interest rate cuts from the Fed than previously expected. This makes the carry trade (simplified: Japanese interest rates – US interest rates) less attractive, because the interest rate differential (the “carry”) is expected to narrow, reducing the potential profit from such trades. This led to the yen rallying 13% in just one month, wiping out the profits from the carry trades. Many investors were forced to close their trades and sell the securities they had bought with the borrowed money. The subsequent sell-off drove stock prices down across the world, Nikkei 225 experiencing the biggest one-day decline since the Black Monday 1987.

What to Keep in Mind?

What is the key takeaway from this? It is hard to predict if such events will be triggered by carry trades in the near future. The investment community is now spending more attention to the risks of carry trades and the August events have been already addressed by the World Economic Forum. However, the abruptness of the sell-off is not unique to carry trades. In general, strategies that rely on borrowed money come with increased risk and can move markets when they go wrong. This includes leveraged* trades that can involve large amount of capital, affecting the security prices. Leverage involves borrowing money to invest in assets, with the goal of earning a higher return than the cost of debt. 

While this article might have made carry trades seem like an inherently bad idea, this is not necessarily the case. However, the leveraged nature of the carry trade makes it prone to large losses if things go wrong, and this should be kept in mind if you are ever considering one. And our investment experts are always open to share their views on such trades.

As the community leader for the Bergos Next Investor, Jami helps to bring relevant investment themes to the attention of the Next Community. This includes explaining general finance concepts as well as informing about current market events.

Jami Seitsonen September 13, 2024

    Subscribe to our quarterly newsletter for all
    the latest updates for the Next Generation

    Copyright Bergos AG. All rights reserved

    Website by noformat

    REGISTER

    Fill the form below to register for this event.