Not so long ago, in the currency market where traders came out to play, a strategy deemed so profitable garnered mass appeal. Unfortunately, a financial crisis of epic proportions struck that made the strategy profitable no more.
Carry trade, as the strategy is called, refers to technique of borrowing an asset in order buy another one with a higher rate of return.
An example would be Anakin Skypipper getting a 1 million USD loan at 1% interest rate from a local bank to buy an uber cool space ship that he could rent out and pay him an at annual rate of 5%. Through this, he is able to make 40,000 USD a year because he profits from the difference between the return of his space ship which is 50,000 USD the cost of his loan which is 10,000 USD.
Carry trade was a popular strategy before the financial crisis struck and caused investors to unwind their positions. Around late 2000 up to 2006, GBP/JPY was one of the most favored carry trade vehicles when interest rates in the U.K. were around 5.00% and those in Japan were among the lowest at 0.25%.
But have you heard, young Padawan? Word on the street is that carry trade could stage a major comeback!
Can you guess which currencies will be used to fund them?
The dollar and the yen of course!
Let me tell you why by starting with the dollar.
Using my magic crystal ball, I see a prolonged period of low rates. For one, the Federal Reserve isn’t at all concerned about inflation, which means there is very little pressure for them to raise rates. An extension of the Fed’s quantitative easing program isn’t hard to imagine either, given that the unemployment rate is still way above its desired level.
The same things go for the yen. While the overall economic outlook for Japan has improved, the Bank of Japan believes that keeping financial conditions loose (interest rates low) is the way to go until signs of deflation easing appear. You might want to take note Japan has been stuck in deflation for the last couple of decades, so it isn’t something you should hold your breath for.
Funds will likely find their way back to the Aussie dollar given the strong growth prospects in Australia. How strong are we talking exactly? Well, the Reserve Bank of Australia (RBA) recently raised its 2011 GDP forecast from 3.75% to 4.25%… And it did this IN SPITE OF THE FLOODS!
If the RBA is so optimistic about growth this year, then maybe we won’t have to wait much longer before we see another rate hike… which of course, would only add to the Aussie’s appeal.
Other high-yielding currencies will probably benefit from carry trades as well. Lately, we’ve been seeing strong inflationary pressures worldwide, and I’m inclined to believe that this should lead to higher interest rate expectations.
This will probably hold true most especially in countries that are booming with growth–emerging markets such as Korea and Brazil. That means keep your eyes on the real and won, kiddos!
While carry trades aren’t all the rage at the moment, it might be wise for you to prepare and brush up on your Carry Trades Lessons. They might be back in style before you know it!