The Carry Trade: Making This Trend Your Friend

There's been a lot of press lately about the Carry Trade, and like all catchy trends in the investing world, by the time it's a routine fixture on CNBC and blogs, the smart money's been made and retail investors are left holding the bag when the bubble bursts (anyone recall housing 2007, oil 2008?). Conversely, the trend is your friend and given the continued decline of the US dollar of late, we may very well see this trend continue for months. In a flat or downward stock market following a 60% move from the bottom, the carry trade may be a nice place to earn a double digit gain in the meantime.

As outlined in this article on Currency ETFs, there are some currencies that are making great gains against the US Dollar and investors could have captured some nice low-correlation gains alongside stock gains in the past few months and this may continue.

What is the Carry Trade Exactly?

Essentially, because the US has a near 0% interest rate and other economies have higher interest rates or are even raising them due to the relative strength and confidence in their economies (like Australia), currency ETFs such as FXA (Aussie Dollar) are on fire. This year, you would have even done better in FXA than the S&P500 (SPY), even given the recent rally.

Chart 1: YTD Return FXA +28% vs. S&P500 +15% [click to enlarge]

With all the talk of the US Dollar being displaced as the reserve currency of choice, we've seen gold rally to all-time highs, which is very much a function of the weakening dollar (see why silver-platinum ETFs are even better investments than gold in a weak dollar environment) as opposed to a supply shortage or industrial demand. Meanwhile silver and platinum benefit from actual real-world industrial utilization and are more leveraged to a weakening dollar even than gold.
However, aside from a commodities trade or trying to pit Australia alone vs. the US, another ETF that goes long the highest yielding currencies and short the lowest yielding currencies is DBV - PowerShares DB G10 Currency Harvest. This one is considered a broader play on the carry trade rather than betting on the relative strength of individual currencies.

Carry Trade Bubble Risk

To be clear, playing the carry trade this far into the dance is not without risk. Prominent B-School professor and oft-doomsayer Roubini has been warning of the imminent collapse of the mother of all carry trades. The video's a bit long, so I'll summarize. He warns that when the carry trade reverses (the bubble bursts) and investors have to cover their short dollar positions, panic will ensue and investors will rush for the exits. In doing so, the dollar will rally to the tune of 25% or more and overseas currencies will crash precipitously. Those that are long foreign currencies and short the US dollar will get crushed. Indirectly, all risky assets will suffer including stocks and bonds like we saw in 2008 into 2009.

This would be akin to what we saw during the global collapse and complete capitulation of the investment world at large in March 2009 where even the weak dollar-gold correlation broke down for the first time in years - and then promptly recovered as we're seeing now. Therefore, if you're a contrarian and want to wait it out for this bubble to burst, you'd want to stay out of commodities, stay out of the foreign currency ETFs and just go long the dollar or Treasuries.

Disclosure: No positions in currency ETFs. Engaged in hedged Treasuries ETF strategy that is net neutral.

Comments

[Benny D.:]

Look. Instead of risking myself on this Carry Trade thing, I would just go 50/50 Long term treasuries (EDV etc) with either Gold, or forign dollar bonds (AWF etc.)

Nov 05 10:36 AM

[mbkelly75:]

I have been looking at it, but did not understand it enough to invest using it. I have done well enough by simply investing in stocks that pay a dividend in a another currency that is one of the stronger ones such as the Loonie or the Aussie Dollar. Thank you for your explanation.

Nov 05 01:22 PM

[Nathaniel C:]

I have recently exited my carry positions. They have gone up too much too fast. AUD/JPY in 2009 has gone from 55 to a recent high of 85--unheard in the currency market. I agree with the author that the easy money has already been made. I am waiting for a correction before establishing any more positions.

Nov 07 12:48 PM