Currency carry: how does carry work when the currency market is changing?
Historically, before the Lehman crisis, the USD-JPY carry trade was the most important trade where borrowing originated from the Japanese market due to the Bank of Japan’s accommodative monetary policy of low interest rates since the 1990s, while conversely, the United States Federal Reserve has kept interest rates high. The interest rate differential between the United States and Japan has prompted many traders to sell yen at low rates and buy dollars for higher rates.
Inevitably, there are two risk factors involved in forex carry trades namely exchange rate risk and interest rate risk. The former impacts a lot when there is a massive movement of the exchange rate and this can lead to a substantial loss of the capital base. The latter defines the profit yield of carry trades positions. The larger the interest rate differential, the greater the opportunities.
The Indian rupee attracts the highest carry in Asia; at around 4% for holding one-year futures contracts on buying rupees against the dollar at a time when developed markets are generating virtually no bond yields. Thus, the rupee climbed more than 1.6% against the dollar in May to beat its Asian peers. However, with a gradual change in the stance of monetary policy based on incoming inflation data in the United States, which was at an all-time high of 5% in May, the unwinding of carry trades may begin to sag. accumulate. At the same time, the rupee fell below 74.00 in no time.
Another case where the carry trade was played out is that of commodity-oriented currencies. The Canadian dollar, which is very sensitive to oil prices and the yen, the low-yielding currency, but also between the Canadian dollar and the US dollar in the wake of the 2008 global financial crisis, when US interest rates were at historic lows and the US dollar was weak against the Canadian dollar.
Historically, falling commodity prices have tended to eliminate differences in returns between currencies, thereby leading to transactions that are forced to unwind, contributing to a decline in the exchange rate of the Canadian dollar and other currency-based currencies. raw materials. In such a scenario, reverse carry trades become profitable as oil prices fall and US interest rates begin to rise. This will tend to lower the exchange rates of the Canadian dollar.
Overall, forex carry trades encourage reflation trades and adjust to the inflation and interest rate cycle.
(DK Aggarwal is the CMD of SMC Investment and Advisors)