Explaining The Carry Trade

I got a question from Tom over at Accrued Interest. Here's the question and my answer. Thought all could benefit from this:

...something that has been bothering me about the carry trade. If I borrow in JPY and Ford Co '13's, I'm making a credit bet and a currency bet. The carry is all well and good, but relative rates should be washed out by expected future currency moves right?

I realize that's like currency 101 thinking, so I'm asking the graduate professor to explain why we still call it a "carry" trade when it's really a currency bet.

This all depends upon where the money ends up. Mostly, however, a true carry is going to have no risk with regard to a company. Most carries are going to go into government debt. A true carry never even really "happens". I've done carries where I sell a country's government debt instrument while simultaneously buying another country's debt instrument. All the while, I'm buying and selling the currency as well. Logistically, it's fun to pull it off and make a buck. With that kind of trade, I'd never even really show up on the books, and will only be in the market for about 2 days.

The thing with this particular carry is that there has been one key element that has perpetuated this into oblivion. For some time, markets around the world have had near zero volatility. Because of that, the carry has continued.

A normal market is more likely to last a short period. If there is a period where economic releases are beginning to get sluggish, then interest rates in that country are going to slide. That's when the carry guys will move in (and why currencies move so much on economic release days). There's billions sitting on the sidelines waiting for a move in debt instruments.

In most instances, this money is sitting in a market looking for a fraction of a percentage. They are also looking to get out of the instrument as quickly as possible because of potential currency volatility. What's happened with this current economic scenario is that with the lack of volatility, the carry guys haven't moved their bets out of the trade. It's become a one-way bet for some time because it kept working. It became perpetual because it kept working. Guys have been doubling up around the world.

What's interesting is the timing of the carry, and the subsequent timing of the move up in equities. Now we're seeing a lot of selling in equities. Interesting how that correlates. Seems some of the carry guys started getting involved with equities. That's probably one of the bigger reasons as to why the equity slide that started last week is still going. Volatility showed up to spoil the party.

With at least $2 trillion in carry that we're aware of, the potential is going to be huge. It's going to be a one-way bet going down, as well. Who wants to take the other side of this trade?