The Most Important Trade on Earth: The Carry Trade

The correlation matrix for import carry trade assets like stocks, bonds, currencies, and risk

The correlation matrix for main carry trade assets like stocks, bonds, currencies, and risk

In general, when professionals refer to the carry trade they mean:

  1. Borrowing money in a low-yielding currency, such as the Japanese Yen
  2. Selling the balance of the loan for a higher yielding currency, such as the US Dollar
  3. Buying something with the second currency

Traditionally this has meant selling things like the Yen and buying US government bonds. The Euro has become another popular currency with interest rates locked near the zero lower bound. Meanwhile the Federal Reserve has discontinued its bond buying program of QE and pressure is mounting to raise rates. Eurodollar futures imply an initial rate hike by June of 2015.

Eurodollar futures have priced in a 25 basis point rise in short term interest rates by June of next year

Eurodollar futures have priced in a 25 basis point rise in short term interest rates by June of next year

With US yields rising and the dollar strengthening overall, many professionals are looking to the carry trade as a way to cheaply fund speculative positions. With government bond yields next to nothing, the carry trade has progressed into dangerous territory: using low yielding currencies to buy the US stock market. Note the strong relationship between the value of the Yen and the S&P 500:

S&P 500 ETF vs Yen ETF

S&P 500 ETF vs Yen ETF

The risk from the carry trade is its highly levered nature. Traders can lose money from several sources:

  • The borrowed currency could appreciate in value against the high yield currency; e.g. the Yen strengthens against the dollar
  • The high-yield currency assets could depreciate in local terms; e.g. the stock market could fall
  • Interest rates could rise in the borrowed currency

As a result, carry traders tend to be hot money: quickly reversing the trade if conditions reverse. The latest round of yen depreciation clearly supported the US equity market as traders borrowed cheap yen to fund speculative US positions.

We are watching the value of the Yen closely for clues on market direction. In addition to moving equity markets, the Yen is highly correlated with credit markets (see correlation heat-map above). The Yen is over 50% correlated with the belly of the US treasury curve. 

As long as the Japanese authorities remain committed to Yen devaluation expect the carry trade to remain in full effect. High leverage means it only takes small movements to destabilize the position. If the yen were to suddenly strengthen, for example during a run on Japanese Government Bonds, it could have a direct impact on US equities prices as carry traders unwind long positions. 

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