The carry trade is a relatively simple concept, as it typically involves borrowing a currency with a low interest rate, and then putting money in a country that offers a higher interest rate. In essence, traders are seeking to exploit the gap in global borrowing costs.
Banks do much the same thing. They borrow from depositors at a rate of say 3%, then lend to others at a higher rate of 5%. In more technical terms, this is referred to as interest arbitrage.
The difference in these interest rates – the carry – is where the return is earned (or cost is incurred), but as usual, it’s not as easy as it sounds if you’re not a financial institution.
The biggest benefit this strategy offers is the possibility for both trading gains (the currency bet going your way), and collecting interest provided by the currency being held. Yet the foreign exchange market can move quickly, and forecasting global interest rates requires a broad lens.
Carry trades work best in an environment of low volatility. That usually means the global economy is functioning well, and there is ample liquidity in the forex market.
With U.S. interest rates near record lows in recent years, a popular carry trade has been to borrow the U.S. dollar and invest in emerging market currencies. That could be high interest rate markets like Turkey, India, Brazil or Egypt. Meanwhile, low rates in places like Japan, Germany, the U.S. and Australia have made those popular funding sources for this strategy.
Major currency pairs are considered to be “carry pairs,” but keep in mind that if safer currencies such as the U.S. Dollar and Yen appreciate rapidly due to a rush out of risky assets, popular carry trades are vulnerable to steep losses.
Forex carry trades became much more common in the 1990s when interest rates in Japan were near zero, and investors saw an opportunity to play the gap with U.S. rates in the 5% range. Things changed dramatically in the U.S. as rates plunged during the Great Recession, and stayed remarkably low for many years to follow.
Interest rates are determined by the supply and demand for capital. On the supply side, the rate at which borrowers are willing to pay lenders is paramount.
Central bank policy ties in closely to this relationship, as moves higher or lower in benchmark interest rates dictate much of the broader lending landscape. As a result, in addition to focusing on sidestepping uncertainty and volatility within the forex market, it’s crucial to remember that carry trades are about more than just calling on movements in the currency market, but also about forecasting interest rates.