Emerging Carry Trade Opportunities for Earning Interest

Includes: FXA, FXE, FXY, SZE
by: Vincent Fernando, CFA

By Dan Ziembienski

Below is a chart of the historical Central Bank interest rates for Europe (EUR), Switzerland (CHF), United States (USD), Australia (AUD), and Japan (JPY) from 2000 to 2010. From this comparison, many basic observations can be made. Note that rising or falling interest rates have generally been extremely consistent in direction and typically have continued for two or more years. Other general observations from this comparison show that the European rate has always been anywhere from 2.25% to 0.75% higher than the Swiss rate; that the Australian rate has mostly remained the highest; that the Japanese rate has by far always remained the lowest; that all the rates generally remain closely correlated in direction but not in amplitude; and that United States or Australia many times leads new cycles in interest rate hikes or cuts. All things considered, these are only generalizations that seem likely to continue into the future, but they are not necessarily guaranteed to always remain true.

Also, carefully note that the Australian interest rate has just recently begun to experience a series of gradual interest rate hikes, while the other nations have all recently stopped cutting their interest rates, with most being at or near record lows.

The currency pair with highest interest rate differential has usually been and still is AUD/JPY. Although other economic data must also be considered, a currency pair with a relatively high and steadily expanding interest rate differential fueled by interest rate hikes, greatly favors appreciating the price of the higher interest rate currency in the pair. This is demonstrated in the monthly chart of AUD/JPY above. You can see that during the entire 2002 – 2008 period of the gradually rising Australian interest rate, the price of AUD/JPY also gradually appreciated. Holding onto an AUD/JPY position during this period, you would have not only earned a high interest rate, but also your position would have appreciated in value more than 50%, making this a very profitable long-term carry trade.

It is important to consider that, historically, higher interest rate differential currency pairs are more volatile. Therefore, after an extended period of strength fueled by a rising interest rate, the higher interest rate currency may rapidly start to depreciate, possibly giving up a significant amount of its prior gains. More importantly, this usually occurs even before any interest rate cuts actually occur, as demonstrated in the comparison of the Australian interest rate vs. AUD/JPY. Therefore, it is not always possible to closely time the best entry and exit of a carry trade just by an interest rate hike or cut alone, because the interest rate number itself is already highly anticipated.

The actual wording of the statement is usually just as or more important than the decided interest rate, because it contains the collective outlook on the economy and intentional hints about future monetary policy. Therefore, when implementing a carry trade strategy, it is important to carefully read the actual wording of interest rate decisions and not just look at the interest rate number alone. It is also important to generally consider how much of the outlook the market has already priced into the current value of the currency.

The earned interest of a held currency pair position is typically referred to as swap. Swap is primarily correlated to the interest rate differential, but is also affected by many other factors. It is important to mention that a large majority of retail FX brokerages do not offer the highest available swap rates, this could affect the amount of interest you earn (or pay) up to a factor 10 depending on which brokerage you choose. This could be an advantage or disadvantage depending on your strategy, but is clearly a major disadvantage for carry trades intended to capitalize on earned interest. If your FX brokerage does not offer swap rates comparable to their corresponding Central Bank interest rate differential, then it is not ideal for executing a carry trade strategy. As an example, at a brokerage offering premium swap, currently holding onto a long position of one 10K mini-lot of AUD/JPY (valued at $8,662 (USD)) earns an incredible variable rate of $5.88 (USD) a day.