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Carry On Trading February 28, 2007

Posted by newyorkscot in Markets.
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There has been some recent discussion / warnings (again) about the perils of the Carry Trade and how it is distorting the global markets by cheapening the Yen.

The Economist just ran an article on Carry Trading, “Carry On Speculating“, and previously “Carry On Living Dangerously” (their titles playing on the name of the trade and the classic Carry On British comedies of the 60s and 70s).

Basically, the carry trade is where an investor borrows money cheaply and invests it in instruments that have higher returns. Often the borrowed money flows into higher risk assets (such as emerging markets), so there are clear dangers in this activity. However, the currency carry trade is even more dangerous since it involves borrowing in one currency (that has a lower set of interest rates) and using that to invest in assets in another currency, so if the currency rate moves against you, your assets will be devalued.

The weird thing though about the Carry Trade is that is goes against economic theory. Normally the FX market displays “covered interest parity” whereby the difference in the currency spot rate and forward rate reflects the difference in the respective interest rates. This in turn would represent an investors expectations that the low interest rate currency would appreciate against the higher interest rate currency. However, since investors are borrowing the lower interest rate currency and buying assets with a higher return in another currency, and hence SELLING the borrowed low interest currency, the carry trade actually applies DOWNWARD pressure on the borrowed currency. As long as low interest rates exist, the currency everyone is borrowing gets key pinned down, and hence more carry trades get done, keeping the cycle going.

Almost all of the recent discussion has been specifically around carry trading in Yen, which has very low interest rates and is pretty much the basis for the global currency carry trading, and hence global hyperinflation. But it is tough to know how much investment there is in carry trades. For example, hedge funds do carry trades through ccy forward swaps which are off-balance sheet. Estimates,  based on the record net “short” positions in yen futures on the Chicago Mercantile Exchange, suggest the total size of the carry trade range as high as $1 trillion.

So, Yen is being cheapened and the risk in global markets continues to increase. If the Bank Of Japan raises interest rates (which they have made noises of doing), the whole carry market could be unwound through the sell-off of the assets that were funded by borrowing all this cheap Yen. According to some reports, it would take a 2% increase in interest rates to undermine these carry trades, but many people believe this is not going to happen any time soon, so they keep doing the trades and the cycle continues.

At some point though, something will happen. And the more the Yen slides (because of the selling of Yen), the more likely it is there will be a sharp recoil.

The next few months will be interesting to watch. Investors beware, you mind find yourself in one of those other Carry On comedies, such as “Carry On Up The Kyber”. Or maybe “Carry On Matron” ?!

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