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What's a Carry Trade Anyway?


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Today's commentary is by Jack Crooks, editor of The Money Trader and World Currency Options.

Greetings Currency Traders!
The words "carry trade" evoke all kinds of thoughts and emotions in today's supercharged financial markets. And for good reason. The carry trade has been the driver of some explosive trends in almost every asset market you can think of from stocks to real estate.

This year, the reversal of "carry trades," (yes there's more than one carry trade!), will create some incredible long-term trading opportunities in the months to come.

Let's examine this thing they call a "carry trade" and look at why it's been such a powerful driver of asset markets in the past. Also, let's look at how the carry trade will continue to drive assets going forward - but for an entirely different reason.


It's Not Rocket Science - It's Just the Spread

Though commentators can make this sound complicated, it's not. Think of it as a simple three-step process and I think you will have the mechanics of a carry trade nailed.

Three-step process that defines a carry trade:

Borrow the low cost currency i.e. low interest rate currency

Covert the borrowed currency into currency of your choice

Reinvest into:
Deposits of other high yielding currencies

Stocks

Bonds

Commodities

Real Estate

Derivatives
The currency you borrow in step one is often called your "carry trade currency" or your "funding currency." That's because this borrowed currency gives you the funds to reinvest as defined in step three. So keep in mind that "carry" and "funding" currency is often used interchangeably in financial literature.

Okay. The process looks easy enough, but why is it, or why was it, so popular? The reason is because it was profitable. It's very enticing to be able to borrow inexpensively, reinvest and immediately achieve a much higher return. There's lots of money to be made on the spread...

Make money on the spread

= Return on Investment in Higher Yielding Assets - Borrowing Cost

...or at least that's the theory.

For example, say you borrow at 1% then turn around and reinvest the proceeds at 6%. You've just earned yourself a quick 5% return without much work. This of course assumes the asset yielding 6% in this example holds its value. If the asset you buy with the carry proceeds falls in value, you have a capital loss. Thus it eats away at the spread that once looked so enticing.

In fact, this is where the problem comes in with the carry trade - it's based on simplistic assumptions. But incredibly, these simple assumptions didn't stop fund managers and institutions across the globe from borrowing trillions of dollars to reinvest those assets. And they add massive leverage to boot.

Simple Assumptions, But No Free Lunch

You need to have three major criteria (which are assumptions when projected into the future) for the carry trade to grow into any significance:

1. Low borrowing rates from a major central bank - as highlighted above, it comes down to perceived profitability of borrowing cheap and buying or lending at higher rates to achieve the spread. But for a global carry trade to take wing and fly there must be a major global central bank behind the trade (Bank of England, European Central Bank, The Fed, Bank of Japan, etc.).

2. Low volatility or weakness in funding currency - if the currency you borrow weakens, or at least remains stable, then your risk is limited to the return available where you invested the proceeds. If the currency you borrow begins to appreciate in value relative to the investment you purchased, then profits begin to fall.

3. Low volatility or strength in invested asset class - As long as the asset class you bought e.g. other currencies, stocks, bonds, etc. with the borrowed proceeds increase in value faster than the underlying borrowed currency, the trade is profitable. But if the assets you bought start to decline in value on a relative basis, your losses can mount quickly.

So there you have it. It's a straightforward process. And if the funds and institutions didn't bet so much money on such simplistic assumptions, the carry trade would be relatively innocuous. Unfortunately, not only did they bet big by borrowing trillions, but they turned around and "leveraged it up" many times over. In other words, they used margin to supercharge their carry trade borrowings so they could buy more stuff. After all, it was working for a long time so why change?


The Perfect Storm

From 2001 through most of 2007 almost all asset classes were moving higher and higher in virtual lockstep. Not only that, the volatility of the move was extremely low.

But the game changed come July 2007 - dramatically. The markets bit back, proving what Milton Friedman told us many years ago, "There is no such thing as a free lunch."

Tomorrow we will examine how the game changed, why the carry trade currencies rocketed higher, and why the new era of the great unwind could change the game for a long time to come and set the stage for some excellent long-term currency trading opportunities.

Greetings Currency Traders!

Yesterday, I explained the mechanics behind a carry trade. I showed you why it's a simple concept that became wildly popular among investment funds around the globe.

I also explained the carry trade is a technique based on flimsy and flawed assumptions about the future. And that future changed tremendously in July 2007. In short, the real world of irrational and flawed expectations changed the game dramatically for the carry trade.

Now let me introduce you to the quintessential carry trade currency, the Japanese yen, and its starring role in the Great Unwind.

A massive amount of investors around the world were borrowing yen to find carry trades back then. In fact, it's estimated these carry trade funds were US$138 billion dollars.

This carry trade credit funded much of the investment in Asia. In fact, investment fund mangers' from across the globe raced to send money to the Asian Tiger economies - the latest hot investment theme. Then of course it all started tumbling down in mid-1998.
And the same institutions who borrowed all those yen, began racing to liquidate their investment positions anywhere and everywhere to raise cash so they could pay back the US$138 billion in yen loans.

All this money racing back into the yen launched a yen rally that lasted over a year. This pushed the yen's value up approximately 46% against the U.S. dollar. That's a huge move in the currency world. But the yen actually appreciated even more against the euro, pound and Australian dollar over the same period.


Fast Forward to 2008

It's an eerie parallel, but this time is a bit different. The numbers are much larger and the risk is more pervasive and dangerous.

Fast forward to 2007 and look at the Japanese yen carry trade. At the end of 2006, analysts estimated hedge funds and other money managers were borrowing at least US$1 trillion in yen. And this doesn't include the many hundreds of billions of dollars domestic Japanese institutions and retail investors sent offshore for better yield.

Plus, money managers use a lot more leverage now than they did in the1990's. That means the impact of US$1 trillion borrowed became magnified many times over. And when you consider that on raw borrowing alone before the credit crunch began, the yen carry trade in 2007 was already seven times larger than in 1998, you can begin to see just how powerful it is when the carry trade starts unwinding.

As I said, in July of 2007 we got the first inkling of a problem. And right on cue the yen bottomed and began to rally. It was the start of the Great Unwind of 2007-2008 and beyond.
More Juice Left in the Yen

Make no mistake. The yen has already started to unwind. But I still say the yen will unwind further. Assuming the yen climbs 46% again, the yen could rise about 21% more. There are three powerful reasons why the Japanese yen could move higher against the dollar and other major currencies in the months ahead:

1. The yen is still extremely undervalued on a fundamental basis. Analysts suggest that the yen has already soared too high. They're saying 100 yen to a single dollar is far enough, because that's the level the yen hit back in 1995. But if you consider that "between 1995 and 2007, consumer prices in the U.S. rose 37% but remained virtually unchanged in Japan. A dollar buys substantially less in the U.S. today than it did in 1995 while 100 yen buys about the same amount in Japan as it did then," according to a recent research piece by Harvard economist Martin Feldstein. Based on this analysis, the yen (U.S. dollar-yen) would have to strengthen to 73 USD/JPY to equalize its inflation adjusted value against the dollar since 1995.

2. Interest rates in Japan are poised to go higher. No doubt the Japanese economy has struggled a bit lately. But the Bank of Japan wants to hike interest rates in an effort to normalize the Japanese economy. And the reason I think this will happen is because we are finally seeing some inflation return to the Japanese economy. It jumped to a decade high of 1.0 per cent in February. This news, along with continue support from growth throughout Asia should provide validation for the BOJ to hike rates.

3. The Chinese wildcard is in play. Each and every day, Japanese business becomes more tightly interlinked with the juggernaut that is China. And until recently, the Chinese have kept their currency tightly controlled, allowing little appreciation. But over the past few months, the Chinese government has allowed its currency to appreciate much faster. I think this is because China realizes that inflation is a dangerous problem and a stronger currency does help to mute inflation by making imported goods relatively less expensive. Why should this impact Japan? Two reasons: First, if China allows its currency to appreciate, it should provide support for an appreciation of the entire Asian bloc of currencies and Japan is a key player in the region. Until now, all the Asian players were very leery about letting their currencies appreciate because they compete with China for exports to the West. Secondly, inflation in China will continue to impact a more tightly integrated Japan, further supporting the BOJ view that interest rates in the country need to go higher, as I talked about above.

So, how far can the yen go now that the carry trade unwind is underway? Below is a chart of a conservative view. I say conservative because if the yen rallies as far this time on an unwinding of the yen carry trade as it did in 1998, or 46%, it means the yen-dollar will rally to 118 (or USD/JPY down to 84).

I do think this is a very plausible target for the yen especially when you consider:

1. The size of the yen carry trade was seven-times larger than last time
2. The massive amount of global unwinding of the derivative orgy still lingering in the system
3. The background fundamentals supporting the yen

So, is there more opportunity in the yen against the dollar - absolutely! But, what's even more exciting is the fact that I expect the yen to rally even faster against yet another major currency - setting the stage for some very exciting long-term profits in the currency market.so keep an eye on it, newstraders