Is The Carry Trade Back On?

by: D. H. Taylor


BoJ is keeping 10-year at zero.

Differential is widening.


Over the summer, the Bank of Japan took yet another drastic step to revive their moribund economy. The Bank made a new move in its quantitative easing by announcing its plans to keep interest rates on the long end of the curve at, or near, zero. Most pundits have long believed that the long end of the curve could not be easily manipulated by a central bank, that, ultimately, market forces were what determined interest rates. The belief is, or was, that the market was far too deep for any central bank to be able to sustain any concerted effort in interest rate manipulation as such.

Currently, the 10-year yield on the Japanese Government bond is yielding 0.093%. For the most, I would say that the BoJ has done a pretty good job of getting interest rates near zero. However, the market may be right in the sense that interest rates are not a near-perfect 0.00%. But, after 25 years of being an FX trader, if there is one thing I have learned, it is that the BoJ ultimately gets what they try to achieve. Their timing may be off, but they mostly succeed.

Going forward, interest rates look set to continue to move higher around the world. Currently, the 10-year in the United States is yielding 2.493%. That differential has been widening, as this chart shows:

Differentail in Interest Rates

The trajectory on the yield for Japan has been muted despite bigger moves in the United States and other parts of the world. If interest rates in the United States continue higher, whereas interest rates in Japan remain largely muted, the carry trade could see very large plays.

In the FX world, at the New York close, brokerages do what is called the "fix." There are two sides to a currency trade, the buyer and the seller. Because of the nature of the transaction, since the transaction is, in essence, a loan between two parties, there is interest to be paid. That interest is determined figuring out an average bank rate (not the central bank rate of the respective country) and then either paying or earning the interest.

In the case of, say, USDJPY, the U.S. side has a much higher interest rate than Japan, if you were long USDJPY, you would be a buyer of USD and a seller of JPY. You would earn the differential of the bank rate. On the flip side, if you were short USDJPY, you would be selling the terms currency, USD, with its higher interest rate, and buying the JPY, the base currency, with its lower interest rate. At the New York fix, the interest rate differential is settled between the buyer and the seller if you were to "carry" the trade over into the new day.

If absolutely no movement whatsoever happened in the FX market overnight, individuals long USDJPY would earn money because of the interest rate differential. Those short, would be paying. If there were no movements in the FX market, quickly you would want to get out of the trade simply because it is a losing bet by virtue of the mechanics of the trade. That, effectively, is going to drive the carry trade higher and higher just as it did back in 2002 - 2008 before it unwound in spectacular fashion.


There is something to watch for because it is not a linear trade. First, whenever there is a movement in the equity markets to the downside, money flows into government bonds; price goes up in the buying and because of the virtue of the inverted relationship to bond prices and interest rates, rates go down. Then, carry traders head for the doors. Quickly.

From what I can see the U.S. economy is going to continue to expand more and more. That is going to push the hand of the Fed. That is going to push the carry trade.

There is a feedback loop that you get from the carry trade. As interest rates move higher, money starts chasing the differential. After all, you can essentially borrow in Japan for nearly zero and then deposit those funds in a bank in the U.S. You earn a nice, tidy sum simply because you can move money around the world. That money that is now in the United States is going to look for a home at a financial institution, and then it turns into a loan. That helps to expand the economy of the United States which, of course, pushes the hand of the Fed a little more. That draws more money from Japan.

What is interesting is that the work the BoJ does is almost for nothing, really. All the money they are creating heads for the doors looking for a better place to earn interest. From what I can tell, it actually perpetuates the problem. If not, Japan's economy would have already been fixed with all of the quantitative easing they have done over the years. But, it hasn't.

For now, and right now, I have been getting in-and-out of the carry trade earning a tidy profit here and there. I have been going long AUDJPY, NZDJPY and USDJPY over the past several months. It has worked despite a large drop in USDJPY over the past several weeks from its recent highs of 118.00.

USDJPY to continue higher

My strategy is to wait until there is some kind of selling in the equity markets with its subsequent move lower in interest rates. I buy at that moment and wait for the dust to settle out from the selling. Then, I just wait for the interest rate differential to draw in some more buyers. That is when I take profits.

Disclosure: I am/we are long USDJPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.