How to profit from interest rate variances

WITH many central banks debasing the value of their currency through monetary easing, investors and traders have been struggling to achieve meaningful yields. The euro, dollar and sterling all offer yields near zero (the yen has been in this position for nearly two decades). Factoring in the effects of inflation, investors and traders are effectively getting negative yields.

In this environment, traders can take advantage of the differential between countries’ interest rates through what is known as the “carry trade”. This involves borrowing money in a currency with a low yield, for example sterling – which is currently yielding 0.5 per cent – and investing that borrowed money into a currency where higher yields can be achieved, like South Africa’s rand ­– currently yielding 5 per cent.

Most retail investors using spread betting platforms will have no currency base risk involved in the trade. For example, trading a yen-Aussie-dollar carry trade – sell yen, buy Aussie-dollar, involving paying interest on the yen, and earning interest on the Aussie – would not require converting sterling (into either yen or Aussie dollar): you can take direct positions in these currencies. Chris Beauchamp of IG likes this particular trade, but warns “carry trades are for experienced investors; to go short on one currency and go long on another involves taking double the risk”. Beauchamp says that the yen carry trade is becoming popular: “People said it was dead, but it is becoming fashionable again.”

For carry trades to work successfully, currency pairings need to remain stable so that gains that are made through yield are not wiped away through price fluctuations. Traders should seek currencies with stable political and economic outlooks. Currency pairs should also have a wide differential in interest rates. But with the onset of monetary easing, differentials have reduced. Neil Looker of City Index says “the small differentials will mean more risk for the investor.” Looker therefore thinks opportunities for short-term carry trades are limited, and advises traders to carefully check the costs. “Profits may be wiped out by the charges involved.” Looker gives the example of the dollar-Mexican peso. Currently the carry charge is 15 pips (which you receive), but the spread between the currencies is about 50 pips (which you pay), putting you down 35 points, assuming no movement in the underlying currencies.

Looker says the trade will work better in the medium-term, playing on macro economic fundamentals. He adds that the dollar-rand trade is attractive and will perform well when the industrial action within South Africa comes to an end.

Beauchamp urges inexperienced traders to be cautious about exotic pairings. “It is surprising how much liquidity drops off when you go into the exotics,” he says, “the volatility spikes, so you need to be sharp”. He says that you need to keep a sharp eye on the economy of the currency and that data sources may be thin, potentially laying a trap.

Profiting from the carry trade in the current environment is difficult. For most traders it may make more sense carrying on without this sophisticated strategy.