One of the most loved currency trading strategies is the carry. This is because the carry trade basically rewards you for sitting tight – as long as there isn’t much volatility in the market. Due to the volatility of the currency market after the global financial crisis of 2008, Forex traders using the carry have decreased. However, during bright spots and times of optimism during the last couple of years, the carry has emerged for relatively brief periods.
What Is the Carry Trade?
Simply put, the carry is a strategy used by Forex traders to make money on interest rate differentials. Countries have benchmark rates set by their central banks, and the carry takes advantage of the difference. With the carry trade, you basically use leverage, borrowing a low yielding currency, to fund the purchase of a higher yielding currency. In Forex trading terms, this means that you go long on a currency pair, whose base rate is high yielding.
One of the most common carry trade pairs is AUD/JPY. This is because Australia traditionally has fairly high interest rate, compared to other developed countries with liquid currencies. Japan, on the other hand, has had a rather low interest rate for some years; indeed, it’s the lowest yielding currency among the majors. If you use your Forex trading leverage to enter a long position on AUD/JPY, as you hold your position overnight, you make money on the difference between the two interest rates – you are carrying the trade over and reaping the advantages of leverage-magnified position.
When Is the Carry Trade Most Effective?
In order for the carry trade to work, the high-yielding currency needs to be gaining, or at least remaining steady, relative to low-yielding currency. So, for AUD/JPY to work on the carry trade, the Aussie has to be gaining ground against the yen, or the exchange rate has to remain fairly steady. Indeed, for the carry trade to work in your favor, you don’t need to earn anything on your capital position. In our AUD/JPY example, the Australian dollar doesn’t need to gain against the Japanese yen. The point is that you are earning money on the interest differential, so capital gains aren’t as important (but they can be a bonus).
As long as the high-yielding currency continues to maintain its high yield, you can earn on the carry trade, as long as the high-yielder isn’t falling dramatically against the low-yielder. (In our example, if the yen were to rise against the Aussie, the capital losses from your long position would likely overwhelm the interest earnings from the differential.) In the past, some individuals and institutional investors have been known to maintain the carry for months – or even years. As long as the high-yielding part of the pair trends mostly higher, and as long as the interest rate remains high, it is possible to continue earning on the difference.
The carry trade also works well during periods of low volatility. During periods of low volatility, currencies tend to continue moving in a certain direction. Additionally, during times of solid economic growth and little upheaval, it is a little easier to maintain a trend. Besides, interest rates are more likely to rise when economic activity is positive. Japan’s interest rate has been so low for so long because an attempt at economic stimulus is being made. However, in Australia, growth was significant enough that interest rates were raised to keep inflation in check. This dynamic resulted in a huge (and predictable) spread that made money easily.
Volatility: Enemy of the Carry Trade
Because the carry trade works well in periods of low volatility, when it is fairly easy to see where things are going, you can see why volatility is a problem. It’s hard to tell what bit of news will send the market charging off in another direction. The current environment is difficult, because you could try to carry AUD/JPY and find that, suddenly, risk aversion is leading Forex traders to send the yen higher – destroying the advantage of carrying the trade to earn on the interest differential.
Another issue is the fact that central banks might cut rates during tough economic times. Australia has seen rate cuts since the financial crisis, and that reduces the spread between the Aussie and the yen, making the carry less profitable. (Because of the leverage involved, any change can make a big difference in the end result.)
Some hope, though, that the carry trade will make a better comeback. It’s a fairly simple and straightforward way to earn money on the currency market, so it’s no surprise that the carry trade is so popular amongst Forex traders.
