You may have heard the term “carry trade” in the past. Essentially, an asset’s carry is the benefit or cost of holding it over time. A trade based on profiting from holding as asset, then, is called a carry trade. Currency traders are a group that frequently takes advantage of this strategy.

Interest rates are one of the most enduring fundamentals behind currency price movements. When rates are expected to rise, a currency benefits because it attracts more capital. When interest rates are expected to fall, a currency weakens as capital moves out to places with a higher return. The carry trade reflects this basic flow of money.

The carry trade is borrowing low-interest currencies and investing that borrowed capital in higher-yielding currencies. In recent years Japanese interest rates were near zero, so a popular strategy was to sell yen and buy the higher-yields in the Australian or New Zealand dollar. The result was getting very high interest rates (over 6%) as well as growth.

While the precise magnitude of the yen carry trade is difficult to quantify, estimates are that over 1 trillion yen were borrowed to finance carry trades at the height of its popularity.

But during the global financial collapse in 2008, the central banks cut rates to rock-bottom yields, and the carry trade became much less attractive. As time went on, it was even seen as risky. Essentially, the carry trade collapsed in 2008 and 2009, not only due to low interest rates, but also due to high volatility.

However, even though global growth and recovery is far from certain, the environment for a carry trade resurgence is now becoming much more favorable. After all, some central banks are increasing their interest rates, and it looks like the policies of further cuts has stopped.

We are even beginning to see interest rate differentials between central bank rates becoming attractive. For example, the spread between the yen and the Australian dollar is 4.4%. So putting your money into the Australian dollar would yield 4.4% more that you’d make holding yen.

The challenge, of course, is how to benefit from that. We could jump into the spot Forex market. A trader could, for example, sell the JPY, buy the AUD and hold it. In spot trading, they would get paid the interest rate difference between the first currency and the second currency. Of course it would be pro-rated.

But there’s a lot of added risk in the spot market. Trades are subject to fluctuations in exchange rates, not just interest rates. As a result, I wouldn’t recommend this method unless you’re experienced in this market. That said, I’m working on some carry trade opportunities right now that could offer a more accessible way into this lucrative play – hopefully, I’ll be able to share my findings with Penny Sleuth readers soon.

Sincerely,
Abe Cofnas
Penny Sleuth

July 15, 2010

Learn How to Profit from the Carry Trade was originally featured in the Penny Sleuth.

They weren’t charging me a late fee. It was a finance charge – like a credit card or mortgage payment. Since when did my doctor’s office get into the finance business?

Actually, I’m not surprised to hear the words “interest rate” and “financing” bandied around almost everywhere by everyone. We live in a world of easy, extended credit. Our mortgages, the government’s debt, corporations’ borrowings and even the stock market are affected by it.

But U.S. interest rates have been going up steadily. That means no more easy money. And one country is affecting the equation. Let me explain…

For 10 years, Japanese interest rates have been zero. That’s practically free money. But that’s not the case in the rest of the world. Interest rates in Iceland are very high in comparison to Japan.

An Icelandic bond commonly yields 10%. Compared to Japan, even U.S. bond yields are better (because the interest rate is higher). So traders came up with a way to bridge this gap in yields. It’s called carry-trade.

Simply put, carry trade is a transaction where you borrow money for cheap (Japan) and invest in another country where the yields are higher (U.S., Iceland). You make the difference in interest rates.

Here’s an example…

Let’s say you borrowed $100,000 from the Bank of Japan at 0% interest. You now take that money and invest it in U.S. bonds yielding, say 4%. That’s a $4,000 yield. At the end of it, you pay back the Bank of Japan its $100,000 and walk away with $4,000 gains. It’s that easy.

It’s no wonder then, that the Japanese 0% environment was a monetary playground for carry traders. Now, as long as Japanese interest rates were zero, carry traders made money. But the Bank of Japan announced this year that it will no longer keep interest rates at zero. By the end of this year, Japanese interest rates might be over 0.5%.

Bad news for carry traders. Here’s why…

We don’t realize it, but nearly every part of the American economy carry trades. “We now have all three major segments of the U.S. economy, the government, corporations and households engaged in the ‘carry trade,’” says Jim Puplava of FinancialSense.com.

The U.S. government is a carry trader because most of its $7.3 trillion outstanding debt is short-term debt. According to Puplava, “Instead of locking in its debt costs, the cost of financing all of that short-term debt will also be rising. The U.S government in effect is playing the carry trade by financing long-term commitments with short-term debt.”

Corporate America is also playing the carry trade game. Corporations too are short on debt and long on expenses. And most of this debt is of the floating rate variety.

Besides, hedge funds and large financial institutions are also borrowing money short to invest long.

Even the average American is a carry trader. We too have borrowed mortgages for the short term through Adjustable Rate Mortgages. And we have invested this money for the long term in our home purchases.

Part of the reason why our mortgage rates are so low is Japan. You see, because of carry trading, Japan is the largest holder of U.S debt. If an American mortgage debt yields 5%, that’s a great investment for a carry trader who has borrowed at 0% from Japan.

But these blissful days of carry trade are coming to an end. The bank of Japan is raising rates. No more cheap money.

In fact, earlier this year, when the bank of Japan announced its intentions, carry traders in Icelandic bonds we so paranoid, they dumped they positions and ended all carry trades. As a result, the Icelandic Krone plunged. And it’s only a matter of time before that happens in the U.S.

With Japanese rates on the rise, carry traders will dump all assets they bought using borrowed Yen. That means they will exit positions in U.S. treasuries, Shanghai real estate, expensive stocks and anything else they bought using borrowed Yen.

We already saw the effects of this dumping in Iceland and the following sell-off in U.S. and emerging market stocks. It’s very simple – all the carry trade money sloshing around the world, will now snap back.

All that liquidity will now return to Japan, where recession is no longer a fear and GDP is expected to grow at a healthy 5.5%. The end of the Yen carry trade has started. All the (cheaply) borrowed Yen in the world will now return home.

That’s great news for Japanese stocks and other asset classes. Over the last two years, the Nikkei index is up about 30%.

With the impending end of the Yen carry trade, all that liquidity will need a place to park. It will find a home in cheap Japanese assets. A smart investor will invest in Japan ahead of this liquidity. Here are some Japanese stocks for you to consider:

When the Yen goes Home…

The end of the Yen carry trade is near. However, it wont be a one-time event. My guess is, it will happen over a period of time. And the impending flight out of American and other securities can be harsh. You’ve been warned.

But that doesn’t mean there’s nowhere to invest. Follow the carry trade money back home to Japan and invest in Japanese assets and securities for the long term.

Regards,

Sala Kannan
July 07, 2006

The Only Country You Need to be Invested in for the Next 5 Years was originally featured in the Penny Sleuth.