The Burden of the Carry Trade

In my last post I described the major strategies used to make money in the currency markets.  The first is the widely used carry trade, where monies acquired in low interest rate countries are used to purchase currency accounts in high interest rate countries.

At first glance, this strategy may appear to need no explanations.  Indeed, it does have simplicity on its side.  But, there are potential pitfalls built into this strategy, and it isn’t as simple in execution as it may appear.  In the first place, a practitioner of the carry trade is making two simultaneous bets: that the interest rate differential between two countries will continue, and that the exchange rate between the two currencies will not decline.  In other words, the carry trade practitioner takes an interest rate risk and a market risk.  Neither can be ignored, but both can, to some degree, be dealt with.

The interest rate risk is the risk that the yield curve of the target country will change, thus raising or lowering the interest paid on local deposits.  The plus side of this risk is that currency deposits are short in duration, so they aren’t affected much by small interest rate changes.  Your defense is simple:  keep a sharp eye on interest rates in the target and home countries, and be prepared to pull out if the interest rate spread narrows to an unprofitable level.

The market risk is potentially more serious and must be handled differently.  Just as with equities, the currency market can rise or plunge on good or bad news.  There are two ways of combating this potential: diversity your holdings over many currencies, and/or hedge your holdings in the futures market. 

For each country in which you hold currency you are taking a country risket  (the market risk specific to your target country) that is similar to the business risk when you invest in an individual company.  One country can experience serious economic or political problems, and cause its currency to fall with respect to most other currencies.  But, by owning many currencies you diversify some of this risk away.  Safety in numbers is the short description of this defensive strategy. 

But, it is also possible that all the currencies you are holding will fall with respect to your home currency.  For many years, owning a euro and almost any other currency in the world was a sure loser against the U.S. dollar.  It has been the reverse for most of the last decade.  This is where hedging comes into play.  Hedging adds costs, however, so your potential earnings on the high interest rate differential will be reduced, but it does protect your capital.  Another way of protecting against the downside is to write covered calls.  Depending on the size of your investment and your risk preferences, either short selling or writing a covered call will let you sleep better.

Personally, I prefer to keep it simple, so I combine the value strategy with the carry trade strategy, and avoid hedging or options writing.  I buy only in countries where I feel their currency is likely to rise (undervalued) or is loosely pegged to the U.S. dollar.  The Brazilian real is of the first type, and the Mexican peso is of the latter.  There are no guarantees, of course, and I could be surprised on either count.  But, having done some homework, I feel confident enough to take the market risk without hedging or writing covered calls. 

Staying with the carry trade strategy precludes pure value plays, such as with China’s Renminbi (yuan).  Along with about five billion other people, I think this currency is purposely undervalued.  But, I don’t hold it because the interest rate paid on this currency is lower than I would earn in a U.S. money market account. 

For a better picture of the carry trade, note the chart below, from Wisdom Tree.

click to enlarge image

Mexico is not shown on their chart—they do not offer a peso fund, but its interest rate would be about the same as India. 

Of the twelve currencies shown, you can expect monies to flow from the six on the right side of the chart to the six on the left side.  Seeking higher earnings, holders of savings in Japan, China, the U.S., Canada, the Euro nations and Korea will move their savings to those on the left.  Not everyone does this, of course, but many will, so there is a definite flow of funds from the low interest rate countries to the higher side.

So, how do you decide where to put your money?  Look at the economic fundamentals of each of the receiving nations and see if their economy inspires your confidence.  This simple test eliminates South Africa from my consideration.  Its economy is not in good shape for now, with inflation high and negative real growth. 

Brazil, New Zealand and Australia are more inspiring—all have reasonably stable economies.  Brazil and Australia have heavy commodity-export dependence, and commodity prices have been good for what they sell.  New Zealand has a reasonably healthy economy, but their currency is so thinly traded (the population of this country is less than five million), that I am uncomfortable with its currency’s stability. 

India is healthy, experiencing high growth and moderate inflation, but I am somewhat concerned with their model of a service-dependent economy, and the interest rate differential is not as attractive as Brazil or pegged to the dollar as is Mexico.  The UK is not attractive because there isn’t enough difference in their interest rate and ours, and they are probably going to follow Europe into a low-growth or recessionary period.

One other item to note: as you might suspect, all the nations on the left side of the chart are experiencing fairly high inflation.  Actually, most of them on the right side are, too—just not as high as those on the left.  High inflation is almost a given when interest rate differentials are so wide.  But, excluding hyper inflation, as a holder of their currency you needn’t be overly concerned, because you are not going to be spending their currency.  As a carry trade practitioner you are ultimately going to sell the currency, not purchase Brazilian or South African goods with it.  Not that inflation is irrelevant to an investor, however.  More important to me are the causes of inflation.  If it is related to printing too much money in order to prop up domestic spending programs (Venezuela, e.g.), then I am concerned—this is the primary seed of hyper inflation.  A Rapid rise in inflation is fundamental to the devaluation of any currency on the world market.  But, with most of the countries shown on the chart, their inflation is coming from commodity prices spiking around the world.  This type of exogenous shock will eventually work itself out, and it is affecting almost all currencies at the same time.  In the case of some currencies, the rapid rise in commodity prices may ultimately benefit them. 

This type of analysis is condensed and superficial, and I offer it as a generalized model of what each investor needs to do before taking on the risks of foreign currency ownership.  Each investor will reach an independent conclusion as what to buy.  Your analysis could easily disagree with mine.  If so, more power to you.  Just be sure to look into the economies of each potential carry trade recipient.

These are some of the considerations I make when deciding on the carry trade.  I encourage those interested in any trading strategy to read the Top 10 Currency Trading Tips From Deutsche provided in an earlier post.  Research and diligence are required for this kind of investing.

Comments

[Mark McHugh:]

Hey Ray,

I'm still just contemplating currency trading (in any form). A while back, I considered DBV. Obviously, I'm glad I held off. Do you have any thoughts about DBV now, or ICI? Margin is not for me.

thanks for the articles

2008 Jun 20 11:17 PM

[Ray Hendon:]

Hi, Mark

I don't know your situation, but as a general idea I like the ETFs of Rydex and Wisdom Tree. The specific ones to buy will depend on the strategy you wish to follow. The carry trade options are limited to about five, and a value strategy is even more limited. I have had good success with both the FXM and BZF funds, but I also like Australia (FXA) as a value play and as a carry trade prospect. China (CYB)) is probably the best value play, in my view, but CYB doesn't hold the yuan, it buys forward contracts, and the interest earnings are unattractive.

For strategy funds, I prefer DBV over ICI simply because I prefer the Deutsche Bank Index over the Morgan Stanley Index--but I have no way of knowing which would be better over the years. Right now, DBV has outperformed ICI by a small margin, but both are young funds.

I have also read of strong recommendations on the Swiss Franc (FXF), but I would encourage you to do some research on this currency--it has a long record of good stability and a haven in the storm type of play, but I don't know what to expect of it as a growth prospect.

I am a long term investor, so I don't look for fast turnover. You may be of a different temperment, so I can't give you advice or opinion of much value.

Good luck.

Ray

2008 Jun 20 11:51 PM

[Mark McHugh:]

thanks ray.

I don't look for a fast turnover, but I hate the anxiety of being under water on anything. I agree with you about the FXA, almost went into that big last fall. What scares me away is, I can't "feel" the Australian economy. I'm sure you know, we've been experiencing a pretty big gap between rhetoric and reality.

I'm glad to see someone writing on currency trading from experience. Please keep it up.

thanks again

2008 Jun 23 07:25 PM

[UserThunder...:]

Finally something on the carry trade.

Mar 02 01:25 PM