Currency carry trade: How does carry trade work when currency market is in state of flux?

Carry trade implies borrowing in low-yielding currencies and investing in high-yielding currencies where the interest rate is higher, thereby earning quick profits. Ideally, economic theory suggests opportunities from price differences of the same instrument should quickly disappear. However, carry trade usually sustains those opportunities unless the expectations of rate cycle changes dramatically. Using the forex carry trade strategy, a trader aims to capture the benefits of risk-free profit making by using the difference in currency rates to make easy profits.

Historically, before the Lehman crisis, the USD-JPY carry trade was the most prominent trade where borrowing used to come from the Japanese market because of Bank of Japan’s accommodative monetary policy of low interest rate since the 1990s, while on the flipside, the US Federal Reserve maintained elevated interest rates. The interest rate differential spread between the US and Japan prompted many traders to sell yen at low rates and buy dollars to earn the higher rates.

Inevitably, there are two risk factors involved in the forex carry trades, namely the exchange rate risk and interest rate risk. The former impacts a lot when there is a massive move in the exchange rate and this may lead to substantial loss in the base capital. The latter defines the profit yield of the carry trades positions. The wider the interest rate differential, the wider the opportunities.

The Indian rupee attracts the highest carry in Asia,; at roughly 4% for holding one-year forwards of buying rupee against dollar at a time when developed markets hardly generate any fixed-income yield. Accordingly, the rupee climbed over 1.6% against the dollar in May to beat its Asian peers. However, with a gradual shift in the monetary policy stance based on the incoming inflation data in the US, which was at decades high of 5% in May, unwinding of carry trades can start to build up. Parallely, the rupee fell below 74.00 in no time.

Another instance where carry trade used to play out is in commodity-driven currencies. The Canadian dollar, which is very sensitive to oil prices and the yen, the low-yielding currency, and 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 relative to the Canadian dollar.

Historically, falling commodity prices tend to eliminate yield differences between currencies, thereby carrying trades that are forced to unwind, contributing to a drop in exchange rate for the Canadian dollar and other commodities-based currencies. In such a scenario, reverse carry trades become profitable as oil prices fall and US interest rates start to rise. This will tend to push the currency exchange rates of Canadian dollar lower.

Overall, the forex carry trades prompt the reflation trades and adjust themselves to inflation and interest rate cycle.

(DK Aggarwal is the CMD of SMC Investment and Advisors)