The carry trade is a forex trading strategy that seeks to make a profit from the interest rate differential of two currencies. This is achieved by going long on the currency with the higher interest rate and shorting the other. Because Japanese interest rates have stayed relatively low for a long time the 'Yen carry trade' is the most popular carry trade.
A Carry Trade Example
It is a popular strategy of many forex traders to focus their trading on those currency pairs that have the largest difference in interest rates, such as the AUD/JPY. In essence, a trader borrows at the lower interest rates and uses these funds to buy a higher yielding currency. By way of an example, if the interest rate on the Australian dollar (AUD) is 4% and the Japanese Yen (JPY ) is 0.5%, taking a long position on the AUD/JPY (buying the AUD and selling the Yen) will pay 3.5% pa in interest. Of course, this is a simple example and does not take into account the interest rate spread that brokers charge and the withholding taxes that may apply to such transactions. The strategy is attractive because the interest creates another income stream for the trader, on top of the profits made from any appreciation in the trade position itself.
The Equities Markets And Carry Trade Correlation
As a general rule, when the economy is doing well carry trades do well and when the market gets jittery they tend to go down (usually harder than they go up). It is a well-known fact that there is a high correlation between the stock markets and the carry trade. There are many reasons why this is the case but here are the two main ones:
- Falling economic fortunes is a sign that central banks may need to make downward revisions to interest rates to stimulate the economy.
- Carry trades are often used to finance other investments such as stock purchases, as the stock market goes up, so does the carry trade.
A good trader must always be aware of the interest rates differentials of various pairs and also the economic data that can influence a central bank to change it's monetary policy. Among other things, high inflation and retail sales numbers usually indicate that a central bank might increase interest rates to ensure economic stability.
The additional interest income that the carry trade pays is often too much of a treat for traders to ignore. This phenomenon often supports the perpetual rise in carry trade currency pairs, especially when world economies are stable. It also explains the correlation between the fall of carry trades and the equities markets when there is a flight from risk, especially when there are economic concerns.