CARRY TRADES / THE FINANCIAL TIMES ( RECOMMENDED READING )

Carry trades

Published: October 11 2009 19:45

Like “profit taking” for stocks, “carry trades” is the answer when clueless about foreign currency markets. A carry trader borrows in a low-yielding currency to buy in a higher yielding one. Trouble is, data is patchy. Monitoring the volumes going through some exchanges can give a glimpse of hedge fund activity, but the actions of banks, individuals and other investors remain a mystery.

Carry trading is supposedly back. If so, it is hard to believe. Last year, anyone borrowing in yen to buy Australian dollars, a popular trade with Japanese housewives, would have lost 45 per cent of their money in three months. That is why some equate carry trading with holding equities – both are great investments until they blow up. Still, carry strategies have outperformed cash since 1999 by an annualised 8 per cent, rising by a fifth this year alone.

Why are carry trades hot again? The common view is they benefit when risk-loving returns. Certainly, such trades seem to work when equities rise, although returns are usually less than half as large as those of stocks. In that case, according to Deutsche Bank, carry trades have got ahead of themselves, returning to 2006 levels whereas equities trail three years behind.

What is more, if carry trades are the rage again due to animal spirits, why is ultra-safe gold at an all-time high? The yen and Swiss franc, traditional borrowing currencies, are also rallying. Perhaps investors reckon they are onto a sure thing.

What can possibly go wrong with borrowing dollars given that US rates will remain low for some time and everyone reckons America’s currency is in structural decline? Meanwhile, punt the money in other parts of the world that are benefiting from all the extra liquidity.

Just like last time, however, it will end in tears. It has to. For the truth is that carry trade opportunities should not exist at all: the whole point of flexible exchange rates is to rebalance things when interest rates get out of whack.

Copyright The Financial Times Limited 2009