Behavioral Macro

Mark Dow's microblog, analyzing global macroeconomic and market issues, often through the prism of our cognitive shortcomings

You Don’t Really Understand the Carry Trade, Do You?

This is the question I always fantasize an insightful CNBC interviewer will ask of his/her guest after the guest offhandedly mumbles something about ‘the yen carry trade’.

Odds are, though, it’ll never happen. 

What is a carry trade and why is it so pervasively misunderstood?

First, a quick bit of history (Quick. I promise).

Back in the mid-90s it became increasingly clear that the BOJ was going to become much more aggressive in the battle against Japan’s deepening deflationary pressures. This unleashed monetary experimentation that eventually brought us concepts like ZIRP (Zero Interest Rate Policy) and QE. Fun stuff.

This produced the following investment backdrop: Japanese rates quickly going to zero, US rates north of 5 percent, and influential economists (including He whose name cannot be uttered) exhorting Japan to induce yen depreciation to reverse inflationary expectations. With this scenario, what was a hedge fund to do? Short the yen against the US dollar. In size.

Not only could you expect yen depreciation, but the large interest rate differential gave the trade a sizable tailwind, or, as fixed income guys refer to it, positive carry. On this position, the yen would have had to move against you (appreciate) 5 percent per year to breakeven. This led, over the 1995-98 period, to a move in USDJPY from 80 to 140. Since the positive carry was a sizable part of the ex-ante total return, it soon became known as the yen carry trade. (Side note: the memory of the move from 80-140 is behind much of the hedge fund community’s enthusiasm for the long USDJPY position today.)

But this yen carry trade was largely unknown outside of practitioners until 1998. Up until that point it was the purview of secretive hedge funds and fixed income wizards. The smart guys. However, that year, triggered by the Russian default, markets saw a disorderly unwind of the considerable risk built up in the previous few. From Russian GKOs to Danish mortgages to NJA currencies, it seemed everything was “funded” by a short yen position. Long-Term Capital Management—and the Wall Street prop desks that saw their trades and copied them for their own books—was at the center of much of this. But many, many others, notably Julian Robertson’s Tiger Management, experienced enormous pain.

The phrase ‘the carry trade’ soon became common parlance in finance. So common, in fact, that these days any time anyone shorts the yen—or any currency with below average interest rates for that matter—it gets referred to by some strategist or equity investor as ‘the carry trade’.

People say this because: one, it vaguely fits people’s memory; two, jargon makes people sound ‘in the know’ like the smart guys; and, three, to the legions of those still consumed by their anger at the Financial World it is laden with all the right pejorative connotations—secretive speculators blowing up our world.

But it is wrong.

Think about it. Who has lower interest rates today, the US or Japan? Right. There is no carry there. How about Europe vs. Japan? Right again. Investors short the yen because they are betting on yen depreciation. Carry plays no role.

What, then, do the pros consider a carry trade? The calculus is really simple. If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade.

This implies that the price volatility of the paired trade is low RELATIVE to the interest rate differential.

Example: if you buy the Australian dollar against the US dollar, the interest rate differential these days is about 3 percent. Not a lot of carry. The volatility of the pair these days, while very low by historical standards, is still about 10 percent. This means your return will be dominated by the appreciation/depreciation of the pair, not by the carry. You can say this trade has positive carry to it, but you cannot call it a carry trade.

The classic carry trade in currencies came from the days where many emerging markets had pegged FX regimes and high interest rates—due mostly to shallow financial markets and lack of policy credibility. But those days are mostly gone. There are very few true carry trades left in the currency space. Currency volatility relative to potential carry is just too high. The only real carry trades these days are in credit—like them or not. And with low policy rates and steep yield curves in the main financial markets, some of them are quite attractive.  Carry on!

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