Post-crisis, the carry trade is a new beast to contend with

IT WAS once the most popular trade in the foreign exchange market and helped fuel the boom in global asset markets until 2007. But with the advent of the sub-prime, and subsequently the full-blown, financial crisis, the carry trade was unwound as investors became risk-averse and piled into safe-havens such as the US dollar and the Japanese yen.<br /><br />The carry trade is borrowing in low interest currencies &ndash; normally the yen &ndash; and then using the money to buy high-yielding assets, such as commodities, equities or bonds, often denominated in a different currency with higher interest rates. Everybody from multinational corporations and global banks to Japanese housewives and private investors had been involved in the carry trade but with the worst recession since 1945 and risk aversion stalking the markets, some commentators thought that the carry trade had disappeared for good. <br /><br />But between March and mid-June there was a revival in the trade as global equity markets rallied and investors became more optimistic about an economic recovery. During this period, if you had bought a basket of commodity currencies &ndash; the Australian dollar, the New Zealand dollar and the Canadian dollar using Japanese yen &ndash; you would have seen a gain of between 20 and 25 per cent. <br /><br />There are three conditions that fuelled the carry trade, and which are needed if it is to return. To a certain extent these all returned in the first half of 2009. Firstly, the funding currencies need to have low interest rates. With central banks in many of the world&rsquo;s major economies slashing rates in an attempt to stave off recession and deflation, traders are now spoilt for choice when it comes to choosing a funding currency. Of course, there are now fewer high-yielding currencies than there were a few years ago. <br /><br />Secondly, high liquidity is crucial because it makes it easier for investors to fund their trading. And as part of their non-standard monetary easing, central banks have been pumping billions of dollars of liquidity into the system, which is great news for carry traders. <br /><br />Finally, the carry trade is profitable in periods of low volatility as this encourages traders to take on more risk. Carry traders are looking to simply capture the difference between the rates and this is dependent on the currency pair not changing in value. <br /><br /><strong>DOUBLE-DIP RECESSION</strong><br />So, should we prepare for another carry trade boom? Well, not quite. In reality, the outlook for the trade is mixed as doubts about the sustainability of the global recovery become more prevalent and fears of a double-dip recession weigh on investors&rsquo; minds. There is already evidence that this has affected the carry trade.<br /><br />Ian Stannard, head of G10 currency research at French investment bank BNP Paribas, said: &ldquo;Conditions have changed a bit now and the carry trade has given up some of its gains that were developing earlier in the year because of a shift in overall market sentiment. The market was driven by optimism and the hopes that green shoots will turn into recovery but we have started to see far more erratic trading,&rdquo; he adds. <br /><br />If you look at the Australian dollar-Japanese yen pair &ndash; a typical carry trade &ndash; then the Australian dollar fell by 40 per cent against the yen between February and mid-June. Since then, the Aussie has been moving between &yen;70 and &yen;80. <br /><br />For the rest of 2009, the outlook for the carry trade is mixed for two reasons. Firstly, the expected decline in global interest rates. Secondly, if equity markets and the economy were to take another dive over the second half of 2009 then there might well be a surge in market volatility. &ldquo;With low interest rates there is far less protection against adverse market moves and so investors are far more sensitive to changes in volatility. If there&rsquo;s a high carry then you are protected to a certain extent from the underlying moves in the spot. In a low carry environment, a slight pick up in volatility would start to force people out of the trade,&rdquo; Stannard explains. <br /><br /><strong>SLOW BUILD</strong><br />That said, investors are not expecting another major financial crisis in the near future and volatility is well below its peak, which could lead to a slow build in the carry trade. However, the expected absence of growth until late 2009 or early 2010 means that the carry trade could still move sideways for the rest of the year.<br /><br />If you are looking to follow a carry trade strategy, then you need to be extremely cautious, given that it would take far less now to see investors exiting that trade. John Kicklighter, market strategist at forex provider FXCM, says that investors are going to have to be more frugal in their approach. &ldquo;Investors either have to accept that they are exposing themselves to great capital risks or be in and out of the market immediately, which can be difficult,&rdquo; he says.<br /><br />Stannard agrees, although he says that there is evidence that Japanese private investors still have some appetite for the trade. <br /><br />This can been seen in the resurgence of uridashi bond issuance in the past month &ndash; foreign-denominated bonds sold to Japanese investors.<br /><br />Stannard says there was a large increase of uridashi issue in June, with issuance amounting to the equivalent of $1.53bn, up from $0.6bn in May. Crucially, most of this issuance was in AU$1.02bn equivalent of Aussie dollar uridashi were issued in June, up from $0.12bn in May. All the signs are that this level of issuance has continued, if not increased, in July. <br /><br />In terms of the broader basket of high-yielding currencies, issuance in July so far amounts to around AU$340m, US$360m, NZ$260m, and 625m of South African rand. <br /><br /><strong>STABLE ECONOMY</strong><br />The normal carry trade is to sell yen and buy a high-yielding currency. However with so many countries now on very low interest rates, carry traders are more limited in their search for high-yield. Kicklighter recommends buying Australian dollars, despite the fact that they are lower yielding than the Brazilian real. &ldquo;The Australian economy is much more stable and the statistics are much clearer than Brazil&rsquo;s. And in Brazil, the financial markets are doing very poorly and are exposed to a lot of risks, whereas recent data showed that Australia has avoided a technical recession.&rdquo;<br /><br />How you perceive the outlook for the carry trade will depend very much on how far you want to look forward. In the short-term, traders are going to need to relate the carry trade to how equities are doing, says Kicklighter, who explains that the correlation between the two asset classes is currently so tight because everything is being driven by sentiment. <br /><br />However, he explains that as sentiment starts to stabilise again you will see a breakdown in that correlation. In the longer-term, fiscal deficits will start to have an impact on where you can get your money. For example, Japan is heading towards negative household savings, which will weigh on the currency.<br /><br />Those who still want to exploit the carry trade will need to behave much more cautiously than they did five years ago. Conditions that are conducive to the carry trade are returning, but slowly. Traders might have to be patient, but they can rest assured that the carry trade is far from dead.