Carry trade
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Sooner or later, every novice trader comes across the term “carry trade,” which most often means making money on swaps. In fact, this strategy is much more complex and interesting than it is usually presented in training courses.
To be fair, we note that the Carry Trade methodology appeared immediately after the abolition of the Bretton Woods agreements, i.e. against the backdrop of the transition to floating exchange rate formation, but it gained the greatest popularity in the post-crisis period, when many developed countries began to adhere to ultra-soft monetary policy. Why did it happen? Now let's try to figure it out.
What is Carrie Trade on the international market?
Despite the fact that in the modern global economy all countries depend on general trends, monetary policy in individual regions differs significantly. An example of such a discrepancy is the difference between the interest rates of the ECB and the South African Reserve Bank.
Let us recall that at the time of writing the review, the European Central Bank adhered to a policy of low rates and carried out a quantitative easing program aimed at improving the financial system and supporting inflationary trends.
At the same time as the ECB, the Bank of Japan pursued a similar policy, and several years earlier the US Federal Reserve System was in a similar situation. To make a very rough generalization, this situation can be called a deflationary trap in developed countries, since even in the United States, consumer price growth remains very unstable.
As for South Africa, in this leading African state a diametrically opposite picture was observed - adhering to a policy of high rates, the monetary authorities fought against high inflation. This situation is not unique, since similar problems are typical for almost all developing countries.
It turns out to be a very interesting situation. On the one hand, all regions are closely connected with each other by trade and international agreements (partly for this reason, a crisis in a developed country ricochets on developing ones), and on the other hand, at times the financial and monetary policies of individual countries can differ radically.
Ordinary citizens employed in manufacturing or the service sector are not interested in such discrepancies, since their quality of life depends only on how they can adapt to the current realities (for example, a resident of South Africa does not care about the level of interest rates on loans in the United States, since he is forced think about how to pay off your own loan, taken out in rands), but for financiers and large investors, the difference in rates is an easy money.
In particular, a bank can take out a loan in foreign currency at a small interest rate, and then issue loans to the population and enterprises of its country at a higher rate. This is one of the simplest variants of the carry trade strategy, but we will be interested in slightly different schemes that can be used on Forex.
Carry trade as a financial pump
Before moving on to a detailed study of the actions of carry traders, let’s remember a little macroeconomic theory and figure out what the central bank rate is and why it is needed. In general, this term refers to the annual percentage at which the Central Bank issues loans to commercial banks.
By adjusting the rate, the regulator influences the entire national economy, in particular, by easing policy, the monetary authorities stimulate domestic consumption and investment, since in this case loans become more accessible, and savings begin to gradually depreciate under the influence of inflation.
If signs of a “bubble” appear in the markets or inflation reaches a critical level, the central bank begins to raise the rate. In this case, loans for households and enterprises become more expensive, and the growth rate of consumer prices gradually slows down.
But this is just the tip of the iceberg, because the discount rate is used not only to calculate loan interest. The fact is that the yield of government and corporate bonds directly depends on the policy of the central bank. But if everything is more or less clear with the latter (the same principle applies here as in the credit sector), then government bonds should be considered in more detail.
A government bond is a security issued by an authorized government body (Treasury, Ministry of Finance, etc.) intended to attract additional funds to the budget.
By selling bonds, the state receives a certain amount of money from the investor, but undertakes an obligation after the maturity date to either pay him interest or buy the paper back at par value (if during the issue they were placed at a reduced rate). The first option is most often used, as it is more flexible and transparent.
As a rule, government bonds have lower yields than corporate debt, but they are in strong demand among investors because the likelihood of a government default is relatively low, at least not comparable to the chance of bankruptcy of even the most reliable private company.
This statement can be argued, because not all governments pursue reasonable policies, but the fact remains that all private companies operate in an environment created by the state, therefore, in the event of political upheavals, they will suffer first of all (they will be forced to pay more taxes, redistribution will begin property, etc.).
So, we come to the most important thing, namely, if we formulate a brief conclusion from all of the above, we get a simple “formula” - the discount rate affects the yield of government debt securities, and its value differs significantly in different regions. Accordingly, all countries can be divided into two large groups:
- The first of them includes states that are attractive for finding cheap loans, but for which it is not very profitable to lend money (due to low rates);
- The opposite camp includes countries whose jurisdictions are attractive to foreign investors (i.e., they pay high interest rates on debt securities).
Thus, if you raise capital in a country with a low rate and invest it in government bonds of a “high-yielding” country, the investor receives income literally out of thin air. This is the classic Carry Trade scheme, which plays the role of a global pump - it pumps money from a country with excessive liquidity to regions where there is a clear shortage of finance.
Risks and pitfalls of Carrie trade
At first glance, it may seem that the considered strategy is a real “Grail” and a “perpetual motion machine”, they say, the main thing is to find sufficient capital and you can forget about all the pressing problems, but this is not entirely true. In reality, playing with interest rates involves the following risks:
- Exchange rates - if the currency of the investment country rapidly depreciates in value relative to the currency in which the fixed capital is denominated, the positive effect of the difference in rates can be completely neutralized;
- Political - as a rule, high-yield securities are issued by governments in difficult situations;
- Legislative - recently, many states have been tightening capital controls and introducing new rules, due to which an investor may face fines.
This leads to an obvious conclusion: the carry trade strategy works best during the phase of economic growth, when financial markets grow synchronously, exchange rates remain stable, and armed conflicts are local in nature and do not spread beyond hot spots.
The influence of the carry trade on Forex
As a rule, the considered strategy leads to the strengthening of the currency of the investment country. This pattern is easy to explain - government bonds can only be purchased for national currency, therefore, before purchasing them, the investor must convert the capital at his disposal.
To make it clear what we are talking about, let's look at a few examples. We mentioned above that there is a significant difference between interest rates in South Africa and the Eurozone, therefore, it is profitable for investors to take out loans in EUR and then buy South African debt securities with their existing capital.
The chart above shows the dynamics of the yield of South African ten-year bonds. As you can see, in 2020 it gradually decreased, which means that the demand for these securities increased, i.e. investors poured capital into them.
Of course, it is quite difficult to understand the specifics of the debt market the first time, in particular, a beginner immediately has a question: if the yield of a security falls, why do investors buy it? The fact is that such strategies are inertial, i.e. they develop according to the snowball principle:
- While the situation in the country remains unstable (for example, in 2015, there were regular strikes by miners and workers in South Africa, the president was at the center of a corruption scandal, students rioted), investors are in no hurry to buy bonds;
- Since there is no demand for securities, the yield on them begins to rise and continues to increase until the political/economic situation returns to normal;
- When the situation stabilizes, investors, without fear of default, begin to buy profitable securities;
- After some time, other major players join these “pioneers”;
- As a result, the demand for bonds grows until they lose their competitive advantage (or until the next crisis).
But let's return to our example. As carry traders invested in South African securities in 2020, they had to convert the borrowed EUR into ZAR. Such transactions are carried out on the interbank market, so it is difficult not to notice them.
In the chart above we see how the EURZAR rate has been declining throughout 2020 - these are the consequences of the Carry Trade. By the way, during the designated time interval, a very funny situation could be observed - many analysts could not soberly assess what was happening, since the USD index, on expectations of a Fed rate hike, was in the range and even increased slightly at the end of the year.
The fact is that under normal macroeconomic conditions, tightening policy in the United States usually leads to an outflow of capital from developing countries, as a result of which national currencies lose ground in relation to the USD and EUR. This is another confirmation of the fact that when working in modern financial markets it will not be possible to limit oneself to the “truths” from standard methodologies.
What conclusion can be drawn from the example considered? It's simple - if there is a bullish trend in the bond market, it is undesirable to open positions against the national currency. The opposite statement is also true - when there is no demand for debt securities (their yields are off the charts), you can try to catch the devaluation wave.
Perhaps, to some readers, the example of South Africa will seem like an exception to all possible rules, since this state has specific features, so let’s consider another situation with the USDRUB pair; after all, the Russian financial market is quite developed.
As has been noted many times, before making speculative and investment decisions, carry traders first compare rates from different countries. We will be interested in macroeconomic indicators of the United States and the Russian Federation.
It is obvious that borrowing money in US dollars and investing it in Russian securities is very profitable; moreover, the potential yield from Russian bonds should be ahead (judging by the rates) of similar indicators in other developing countries. Despite the fact that for some time Russia was in a rather difficult situation due to the collapse of oil prices, in 2020 investors took a risk and took advantage of the opportunity provided.
As a result, bond prices began to rise, and their yields began to naturally decline. We can clearly see this trend in the graph presented above. The situation is very similar to the events in South Africa, isn't it? Now let's see how this trend affected the USDRUB exchange rate.
As they say, comments are unnecessary - serious demand for OFZ supported the ruble, moreover, the market even ignored the fact that the Russian budget was in deficit due to low oil prices. It is noteworthy that the same incident happened to some Russian analysts as to their colleagues from South Africa - they did not take into account the actions of carry traders and therefore expected to see a devaluation of the ruble throughout 2020.
By the way, in order to fully appreciate the real strength of the carry trade, you can compare the dynamics of USDRUB and USDCAD, since the quotes of both pairs depend on oil prices, only in the first case the Central Bank keeps high rates, and in the second the regulator adheres to a more lenient policy.
The discrepancy is noticeable to the naked eye, although there is also a correlation. In general, the conclusion is exactly the same as in the case of EURZAR - positions in the ruble should be opened together with carry traders. Of course, this rule does not apply to intraday trading.
Let's sum it up
Today we looked at the mechanism of the classic carry trade strategy, which is used by large players with access to cheap money. Unfortunately, Forex traders often simplify this technique to banal earnings on swaps, but without understanding market processes they almost always fail, since price movements against the position often eat up not only interest income, but also the entire deposit.
To avoid such a sad and natural outcome, we recommend simply monitoring the actions of carry traders and using them to confirm/refute long-term signals obtained using technical systems focused on the long term.
As for the features of the Carrie Trade tactics itself, it has specific advantages and disadvantages. Firstly, this strategy is available only to large investors, often institutional ones, since it is easier for a fund or bank to attract loans and circumvent legal restrictions on the movement of capital.
Secondly, making money on the difference in rates is especially relevant during periods of general peace and prosperity, but during crises, investors prefer to invest money in reliable securities (for example, American Treasuries), precious metals and cash.
Thirdly, the more stable the currency of the country of investment, the more profitable this jurisdiction is for carry traders, because making money on bets is half the battle; it is also necessary to convert the capital back to withdraw it to the main account and pay interest on borrowed funds.
And the last feature is not so obvious, but it cannot be ignored. The fact is that although the carry trade strategy helps fill the state budget, in the long term it leads to an outflow of capital from the country, since investors eventually withdraw more money from it than they invested (adjusted for interest). This circumstance creates additional tension and provokes some regulators to create various barriers, prohibitions and restrictions. Source: Dewinforex
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