Understanding carry trade

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Understanding Carry Trade
MARCH 2007

Emergence of the international carry trade
Historically it was typically commercial banks that exploited the carry trade by borrowing cheaper short-term funds in their domestic credit markets (for example in the short-term money market) and lending at longer maturities in the same domestic credit market (either by making loans tocorporate or individual customers or by buying government or corporate bonds). It was this spread between short- and long-term funding costs that made it attractive to “create credit”. In the early part of the business-cycle expansion when short-term interest rates were usually lower than long-term rates, money and credit growth accelerated. To curtail monetary growth as inflation picked up, centralbanks would raise short-term rates until the yield curve was either flat or inverted. However, in recent years this phenomenon has spread from domestically oriented banks to a much wider range of internationally oriented financial institutions. Two factors have helped to create the phenomenon of the international or cross-currency carry trade. First, the enhanced efficiency of the credit markets, drivenpartly by the development of information systems and risk management technology, especially computer-driven trading systems featuring automated stop-loss options and a variety of protective derivative contracts, plus the diffusion of these trading techniques, has greatly increased the ability of institutional and even medium or small investors to participate in these transactions. Second, the“Great Moderation” * caused by the improvement in macroeconomic management techniques over the past decade and a half has played a significant role in reducing volatility in a range of markets, encouraging investors to take risks across asset classes that they previously would have been reluctant to contemplate.

Recently, we witnessed a sell-off in risky assets and the unwinding of associated yencarry trade, triggered by an abrupt shift in expectations. This time it was initiated by a mini scare in China that carried over into more developed markets, but has been mainly sustained by a growth scare in the US. We share here views of John Greenwood, Chief Economist of AMVESCAP, parent company of INVESCO, on this topic.

Funding currencies for conducting carry trades and conditions for bullmarkets in asset prices
With the normalization of monetary policies in the past two or three years, the yield curves in most major economies are now either flat or inverted. As a result the scope for funding carry trades has been narrowed down to the Japanese yen and the Swiss franc. In the current bull market in global equities and commodities which began in 2003, prices have been driven upwards bya combination of business cycle-related factors: 1) Monetary conditions have been generally accommodative, as reflected in low real rates and, until last year in the US, a positively sloped yield curve. 2) Strong corporate-earnings growth has contributed to stronger share prices. 3) Strengthening global demand has helped push up commodity prices. 4) With the presence of many more institutionalplayers in the commodity markets, prices appear to have been driven much more by speculative investors than in the past. The creation of ETFs, for example, have made it much easier for speculators to participate and therefore a lot more speculative capital has gone into commodities than would otherwise have done so. Broadly, therefore, the international carry trade will continue to be actively pursuedas long as: 1. there are low yielding currencies available to be borrowed to finance the trade, 2. the current business cycle is perceived to be still in the expansion phase, and 3. low volatility conditions prevail.

Low yielding currencies and low volatility create opportunities for carry trades
International Yield Curves %
8 7 6 5 4 3 2 1 0 3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y...
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