Currency Carry Trades

David Champeau
Jun 17, 2005

In the Bank for International Settlements (BIS) Quarterly Review (pdf) dated March 1999 there is a section titled "The yen carry trade and recent foreign exchange market volatility." This report describes the phenomenon known as the "carry trade" and then explains what happened in the foreign exchange markets with regards to the Japanese yen during the period from 1995 to 1998. Here are some quotes from the report.

"The yen carry trade has reportedly been a fairly widespread strategy since the yen started its declining trend in the spring of 1995. Investors could borrow cheaply in the Japanese money market and invest the proceeds in a wide array of assets ranging from US Treasuries to high-yielding emerging market securities. In fact, in 1996 and early 1997 high interest rates in East Asian money markets and stable dollar exchange rates attracted much of these funds. This strategy paid off as long as the yen did not appreciate and other East Asian currencies remained firmly pegged to the US dollar."

In fact, from April 1995 to July 1998 the Japanese currency went from 80 to 147 yen per US dollar. A period of 3.25 years and a loss of 66% purchasing power. From August 1990 to September 1995 the Bank of Japan had lowered the Official Discount Rate from 6% to 0.5%. The US 3-month TBill rates were between 5% and 6% and longer duration bonds over 7%. Thus was born the "Yen Carry Trade."

Of course this ended sadly in 1998 when the dollar fell by about 9% in the period between August 31 and September 7, 1998 and then by a further 12% on October 7 and 8. That was the end of the yen carry trade.

In December 2004 the BIS published the report (pdf)"Why has FX trading surged? Explaining the 2004 triennial survey." The report states "The surge of activity between banks and financial customers could be a
manifestation of the broad search for yield that has characterized financial markets in recent years (BIS (2004)). In their search for yield, both "real money managers" and leveraged players followed two key strategies that targeted the same currencies: one based on interest rate differentials and the other on trends in exchange rates."

"The first strategy exploited the forward bias by investing in high-yielding currencies. A popular form of this investment strategy among leveraged players and real money managers was the so-called "carry trade". In a carry trade, an investor borrows in a low interest rate currency, such as the US dollar, and then takes a long position in a higher interest rate currency, such as the Australian dollar, betting that the exchange rate will not change so as to offset the interest rate differential. While the dollar depreciated and the interest rate
differential persisted, such investment strategies were profitable and a likely factor contributing to turnover growth. Reportedly, the three main funding currencies were the US dollar, the yen and the Swiss franc. The main recipients of the borrowed funds included sterling and the Australian and New Zealand dollars, as well as a number of emerging market currencies. This is consistent with a strong increase in turnover in the Australian and New Zealand dollars: by 98% and 152%, respectively.

"The second strategy involved momentum trading, where investors took large positions in currencies aimed at exploiting long swings or "runs" in exchange rates. Such trades added support to the ongoing trends. Following the April 2001 survey, there was a strong pattern of dollar depreciation as the price of a dollar in different major currencies fell steadily until early spring 2004. Dollar depreciation ranged from about 15%, against the Canadian dollar and Japanese yen, to more than 30% against the Australian dollar. To test the hypothesis that interest differentials and exchange rate trends may have played an important role in explaining the growth of turnover, we conducted a statistical analysis using the major traded currencies and 1992­2004 survey data. The results show that turnover growth rises with increases in the interest differentials of major currencies against the US dollar and with the magnitude of exchange rate changes against the US dollar in the year prior to each survey.

"Beyond the position-taking related to profit opportunities associated with exchange rate trends, such runs may also be associated with growth in hedging-related turnover. Multinational firms face greater incentives to hedge in the face of long swings in currencies in order to minimise losses associated with currency positions. For instance, the European exporter invoicing in dollars in the midst of a long run of dollar depreciation has an incentive to hedge against further depreciation. The activities of banks and currency overlay managers (COMs) in providing hedging services have also contributed to turnover growth. The growth in outright forwards between 2001 and 2004, as reported in Table 1, could reflect heightened interest in hedging. In their search for yield, investors' interest in currencies as an asset class was reinforced by disappointing yields associated with equity and bond markets. A comparison of returns in stock and bond markets with those experienced by foreign exchange reveals a contrasting picture. As returns on stocks and bonds waned, investors found currency strategies to be quite profitable over the 2001­04 period. Graph 2 plots data since the 1998 survey for exchange rates, stock prices and bond yields. Following the 2001 survey, there was a long run of dollar depreciation that was actively exploited by investors. However, both stocks and bonds presented less attractive investment opportunities. It can be seen that, in general, equity markets were falling well into 2003 before beginning an upward run that lasted less than a year. Bond yields were low and fairly flat over the period. So the strong trend in the foreign exchange market offered an attractive alternative to stocks and bonds."

Of course what they are describing here can be called the "US dollar Carry Trade."

The report concludes that "Market observers remark that macro hedge funds may have begun to shift away from currencies towards commodities or domestic short-/long-term interest rate carry trades. In addition, should US interest rates rise further, this could reduce the attractiveness of carry trade strategies and hence turnover in the foreign exchange market. So while the evidence supports the relative attractiveness of foreign exchange as an asset class, the level of investor interest in currencies is not certain to persist in the
future."

We know that the US Dollar Index went from 120 to 80 in the period from July 2001 to Dec 2004, 3.5 years and a loss of 33% (using round numbers). This defines the period of the dollar carry trade.

One of the keys to understanding the Forex markets these days is interest rate differentials. While the news media still focuses on the US "twin deficits" the Forex market is focusing on something else. The March 2005 BIS Quarterly Review states "In the last quarter of 2004 the combined value of trading in interest rate, stock index and currency contracts on organised exchanges fell by 3%, to $279 trillion. The slowdown in global activity was due solely to the stagnant short-term interest rate segment; long-term interest rates, stock market indices and currencies registered solid growth. Notional amounts as of year-end returned close to the values prevailing in March, as a huge expansion in the first half of the year outweighed the declines in the second half."

The March 2005 BIS report "Triennial Central Bank Survey (pdf)- Foreign exchange and derivatives market
activity in 2004" states "between June 2001 and June 2004, while turnover figures are a measure of
April-related activity only. After adjusting for double-counting in local and crossborder transactions among the reporting institutions, the notional amounts of outstanding OTC contracts rose by 121% to $221 trillion at end-June 2004 (Table C.5). This was a much faster rate of expansion than the 38% recorded in the three years between 1998 and 2001. Reflecting the developments in turnover, expansion was stronger for interest rate products than for exchange rate products."

The report also states "Global daily turnover in foreign exchange and interest rate derivatives
contracts, including traditional foreign exchange derivatives (outright forwards and foreign exchange swaps) rose by an estimated 74%, to $2.4 trillion."

So while the US deficits are measured in 100s of billions of dollars, the banks are seeing trillions of dollars turnover EVERY DAY in foreign exchange markets.

On Friday June 10 we saw the announcement of another $55 Billion or so US trade deficit. The US dollar soared against all the major currencies. The Forex market is not reacting to this number, it is reacting to the relative change in interest rates.

One Monday June 6 Bloomberg ran a story titled "Australian Dollar May Fall on Expectations Rate Gap Will Shrink." On Monday June 13 I found two articles, one Reuters and one Bloomberg that discussed the changing sentiment in the Euro and the change in relative interest rates.

Has the "Euro carry trade" started? According to the Federal Reserve Bank of St. Louis publication International Economic Trends the Euro Area "Narrow Money" is expanding at an 8% rate at the end of 2004. In the Morgan Stanley Global Economic Forum dated February 24, 2005, Joachim Fels says "And last but not least, with the Fed likely raising interest rates further at the next couple of meetings and the ECB likely on hold, the Euro carry trade should become increasingly popular."

The Japanese yen carry trade lasted 3.25 years. The US dollar carry trade lasted 3.5 year. The Euro peaked in December 2004. If the Euro carry trade is on and lasts as long as the yen and dollar carry trades, then the Euro will continue down until sometime in 2008. A 30-40% loss in the Euro/Dollar exchange rate would put the Euro back at its 2000-2001 lows in the low 80 cent range.

Another reference: http://www.morganstanley.com/GEFdata/digests/20050224-thu.html

Jun 17, 2005
David Champeau
email: champeaudavid@yahoo.com
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