Carry Trade — Why Did It Work and Why It Won't Anymore

Carry trade is a kind of Forex trading where low-yielding currency is sold for the high-yielding one and the produced difference between the yields is gained by the trader; usually, the gains are made bigger due to the involvement of a high margin leverage. So, what are the yields of the currencies? Each currency has an overnight interest rate associated with it. If you trade via a broker, you buy and sell currencies without physical delivery, so when you buy a currency, you should get paid an interest from a broker, because he gets to "store" and "use" that currency, while you hold the position. If you sell a currency, you should pay an interest because you "hold" and "use" the currency you sold while the position is open. Since in Forex you trade the currencies in pairs, you will get the difference between the long currency's interest rate and the short currency's interest rate. If you sell GBP/JPY pair and the Bank of England's interest rate is 5.00%, while the Bank of Japan's is 0.50% you will lose 4.50% interest on this position. If you would buy this pair, you would gain this difference. In reality, brokers apply some commission to these differences, so you will lose more on negative interest and earn less on positive.

These rate differences would not be so attractive if it was not for the high leverage that allows opening huge positions to earn from those rates. With 1:100 leverage, you could get 450%/year holding a long GBP/JPY position in 2000's. With a higher leverage and a higher rate difference the results are even more impressive. South African rand has 12.0% interest rate associated with it. Buying ZAR/JPY with 1:400 leverage could yield 4600% a year (if you could sustain the potential depreciation of the rand against the yen, of course).

There is no surprise that from 2001 to mid-2007, Forex carry trades were extremely popular. Such currency pairs as GBP/JPY, EUR/JPY, AUD/JPY, and NZD/JPY brought thousands percent of profit through the interest rate difference only; considering that those pairs also rose tremendously during that period, such positions have made some people very rich.

So, what happened in 2007 and why carry trade positions are not very popular nowadays? The global economic crisis spurred by mortgage lending crisis in the USA triggered the growth of global volatility. Central banks had to cut the interest rates and started to focus on stimulus, while high-yielding currencies started a correction. Higher yields are always associated with higher risks, so when the global risks increased, the carry traders began to close their positions, amplifying the wave of decline across those currency pairs. During the next few years following the initial fall, all those popular carry trade pairs moved sideways with a small downward slope.

Carry trades did not vanish from the Forex market completely — they just became much less popular and no longer last for years. Now, carry traders prefer to buy at the local bottoms and hold the pair for weeks or even days to gain their interest rate difference. Such situation will probably prevail while the global economic growth remains in danger of another recession.