Carry Trade: What is it and How Does it Impact the Financial Markets?

Markets on 5 August are awash in a sea of red, with widespread carnage everywhere you look. With drops in crypto, oil, equities and Treasury yields – and with gold spot prices beginning to chart a downward trend – it seems nowhere is safe. 

The event that set things into motion seems innocent enough; a decision by Japan’s central bank to raise interest rates by a mere 0.25% on 31 July 2024 ^[1]. This sparked off a mass unwinding of carry trades across global markets, resulting in the dramatic sell-offs we’re witnessing.  

To understand why, we first need to take a look at a commonly-practised trading strategy, the carry trade.  

Key Points 

• A minor interest rate hike by Japan’s central bank triggered massive unwinding of carry trades globally, leading to significant sell-offs across various financial markets including crypto, oil, and equities. 

• Carry trades involve borrowing in a low-interest currency to invest in higher-yielding assets. 

• Changes in central bank interest rates, like the recent one by the Bank of Japan, can drastically alter the profitability of carry trades, causing large-scale adjustments in global financial markets. 

Understanding carry trades 

Before diving into the intricacies of implementing carry trades, it’s essential to grasp the fundamentals of how this strategy operates. 

What is a carry trade? 

In a carry trade, an investor borrows a low-interest currency to invest in a higher-yielding asset (or a currency with a higher interest rate).  

The idea is that the returns from the higher yielding asset or currency will cover the cost of borrowing the lower-interest currency, with the investor pocketing the difference as a net gain.  

The larger the difference between the two currencies in a carry trade, the more potentially profitable the trade becomes.  

Example of a carry trade  

Let’s examine how a currency carry trade works. Assuming Currency A has an interest rate of 0.1%, and Currency B has an interest rate of 4.5%, a forex trader can set up a carry trade to potentially make a profit.  

To do so, the trader shorts the lower-interest currency (Currency A) while simultaneously going long on the currency with the higher interest (Currency B). In other words, they borrow Currency A to purchase Currency B.  

Profit potential of carry trades 

Using the above example, the profit potential of this currency carry trade can be calculated as follows, assuming a nominal sum of $100,000.  

• [(0.045 – 0.001)/365] x $100,000 = $12/day (approx). 

Note that actual results may vary as banks utilise overnight interest rates that fluctuate day by day.  

As you can see, currency carry trades can potentially generate a steady stream of profits. And while the potential profits aren’t very large, carry trades can be executed using leverage (as is common in forex trading) to spike profits to lucrative levels. In our hypothetical example, a leverage of 10:1 would increase the potential profit to $120 per day.  However, it’s important to note that while leverage can improve returns, it also increases risk, potentially magnifying losses just as much as it can increase gains. 

Additionally, don’t forget that the value of currencies relative to each other are in constant flux, due to the myriad factors that influence exchange rates. This creates additional profit potential for a carry trade to produce capital appreciation in addition to daily interest revenue.  

Benefits of carry trades 

Risk-tolerant 

To be sure, carry trades only work when both currencies maintain a sufficiently large difference in interest rates. This means carry trades perform well during periods of low volatility, when the currencies being traded remain fixed relative to each other.  

This is also why carry trades are a popular strategy, as they offer lower risk compared to other forex strategies. The idea is to continue earning a steady stream of interest revenue, while any capital appreciation is seen as a bonus.  

Portfolio Diversification  

Carry trades can also be applied across different asset classes to diversify risks and avoid being overly concentrated in the forex markets. This can be achieved by borrowing a low-interest currency and then using it to purchase stocks or bonds denominated in a currency with a higher yield. 

Carry Trade Risks and Challenges 

Of course, no trading strategy is without its weak points and carry trades are no different.  

The carry trade strategy is vulnerable in high-volatility environments, when the value of both assets used in the trade can rise or fall sharply within a short time period. This volatility risk is further amplified if leverage is used in the trade.  

Market volatility increases when uncertainty and fear rises in the market; this can stem from various factors such as unexpected economic performance, changes in policies, and – most importantly – central bank interest rate policies.  

When central banks make interest rate changes, this causes a significant impact on the exchange rate between currencies, reducing the profitability of a carry trade. Investors may then rotate into other currencies as they continue to seek profit.  

Remember that the market can be irrational, and hints of incoming interventions from central banks may be sufficient to cause currency pairs to fall in value, turning a profitable carry trade into a losing one.  

How Carry Trades Impact the Financial Markets – The story of the Japanese Yen 

Now that we’ve discussed the fundamentals of the carry trade, let’s continue our tale of the Japanese Yen and its role in the current market downturn.  

Recall that a carry trade relies on currencies used in the trade remaining stable.  

Since 1995, the Yen had been kept at between 0% to 0.5% interest; in fact, between 2016 to February 2024, JPY had an interest of negative 0.1% ^[2]. 

Thus, for around two decades, the Japanese Yen was one of the most stable currencies available, prompting forex traders to incessantly target JPY for their carry trade strategies. 

This strategy became known as the yen-funded carry trade and is estimated to be as high as USD $4 trillion in total value ^[3]. 

In July 2024, the Bank of Japan raised the interest of the Yen to 0.25%, causing the Japanese currency to strengthen against other major currencies ^[4]. The upswing also attracted forex punters to long the Yen to generate capital appreciation, with the added demand further adding upwards pressure on the Yen.  

This disrupted the forex markets, making yen-funded carry trades suddenly less profitable.  Investors, now facing forex losses and higher interest on their JPY loans, scrambled to unwind their yen-funded carry trades.  

Many are selling their US equities and other assets to obtain USD, which they then convert back into JPY to repay their yen-denominated loans.  

At the time of writing, the unwinding of the global yen-funded carry trade was estimated at USD $500 billion – which analysts say is only halfway done ^[5]. All told, we could see around USD $1 trillion in carry trades unwound by the end.   

Is the Bank of Japan’s rate hike solely to blame? 

It may seem that blame for the current market turmoil is to be laid at Japan’s feet, but that would be oversimplifying things. Afterall, global economic factors are highly complex and can often play out in unexpected ways.  

The Japanese rate hike coincided with a weakening US labour market, as unemployment climbed to 4.3% in July ^[6]. This unexpected metric was read as a sign that the US Fed had kept interest rates too high for too long, sparking off fears of a recession taking place. 

Also, there had been worries that the recent stock market rally – driven by optimism in AI – might be running out of steam, with investors bracing for a market correction. This came to pass with disappointing earnings from Intel and Amazon, which saw the Nasdaq dragged down by 2.43% in early August ^[7].  

And let’s not forget other significant global instabilities, including the ongoing Russian-Ukraine war, continued weakening in the Chinese economy, and shifting political winds with Joe Biden bowing out of the US Presidential Elections.  

Each of these events, and not just the Yen rate hike, should be considered as contributing factors in the current stock market downturn.  

Trade popular global stocks and currency pairs with Vantage through CFDs 

Carry trades can work well under the right conditions and may offer opportunities for potential profit, as well as capital appreciation from forex movements. While there is a massive unwinding of the yen-funded carry trade taking place, this doesn’t mean investors should give up on the popular strategy completely.  

Afterall, an interest rate of 0.25% is still relatively low compared to some major currencies, which means carry trades can still be viable with the right currency pairing although it does not guarantee success.  

Alternatively, consider trading contracts-for-differences (CFDs) on popular stocks and currency pairs to take advantage of price action without taking direct ownership of shares or currencies.  

Enjoy the flexibility of going long or going short in your trades and save on trading costs with Vantage low and transparent fees. Open a live account now and start trading. 

CFDs and Spreadbets are complex instruments and come with a high risk of losing money rapidly due to leverage. 72.5% of retail investor accounts lose money when trading CFDs and Spreadbets with this provider. You should consider whether you understand how CFDs and Spreadbets work and whether you can afford to take the high risk of losing your money.  

References: