Carry Onward: The Tale of Two 'Safe Haven' Economies

“Little is ever new in the world of finance. The public has a euphoric desire to forget”-J.K. Galbraith, 1929.

There once were two countries – both considered “safe havens” yet with two distinct economies.  Both had native currencies floating freely based on the ebb and flow of their respective economic conditions.

The first country suffered laborious bouts of economic stagnation and central bankers, determined to spur both economic expansion and risk-taking, sliced short-term deposit rates from 2.5% to less than 1%.  The second country was in the midst of an extraordinary run-up in real estate prices and central bankers, eager to slow things down a bit, swiftly raised its short-term deposit rates to 5.25% - causing the interest rate differential between these two countries to widen to an unprecedented width.

It didn’t take long for the investment community to take notice of this interest rate differential.  An investor could sell (or, borrow) from the country with sub 1% rates, converting and depositing those funds into the first country’s bonds while collecting the higher interest rate.

It was a party atmosphere for the investor as massive amounts of cash continued to flow out of the low interest rate country and into the higher all the while currency rates remained stable and interest rate differentials kept paying an incredible yield!  Finally, there was a free carry-out lunch for everyone!

After fourteen months, the party halted violently and without warning as the country with 5.25% interest rates witnessed an 85-year old investment banking firm go broke.  Policy makers, catching the first whiff of further banks and securities firms failing, abruptly reversed course and began cutting its own interest rates.

In fact, as the central bank hastily reduced short term interest rates, a full-fledged panic gripped this “carry trade.”  Not only was the interest rate differential swiftly evaporating but, the party goers became fearful – very fearful – of a currency crash as participants, like five car lanes attempting to merge into two, were unwinding the trade as fast as possible.

This period of 2007-2008 will be remembered by many things – one being the great volatility and ultimate implosion of the U.S. dollar / Japanese Yen “carry trade.”

The Carry Trade

The “carry trade” is buying a currency with a higher short-term interest rate while simultaneously selling (borrowing) a currency with a lower short-term rate.

In the plainest sense of the carry trade, the participant borrows in a lower interest-rate currency, converts the proceeds to the higher interest-rate currency, and invests in securities denominated in that currency.  The participant in the carry trade hopes to capture the differential between the interest paid (via. currency borrowed or sold) versus the interest received (via. currency purchased).  Indeed, a useful and broader definition of the carry trade would cover any investment strategy that involved changing out of low-interest-rate assets into anything else including – emerging market debt, equities, real estate, and commodities.

Carry trading isn’t necessarily about forecasting the direction of any currency pair (e.g. U.S.$/YEN), but to bet that the net interest received (i.e. interest rate differential) will be higher and thus, offset any negative fluctuation in the currencies.

Here’s an example: A trader borrows $10,000 U.S. dollars from a U.S. bank, converts the funds into Chinese renminbi (CNY) and deposits those local funds into a Chinese bank.  Let’s assume that the Chinese bank deposit pays 6.0% interest and the U.S. interest rate is set at 0.50%. The trader stands to make a profit of 5.5% as long as the exchange rate between the two countries remains unchanged.  If the trader in our example uses an industry standard leverage factor of 10:1, then he can stand to make a whopping profit of 55%.

Risk/Reward:

• The risk(s) are uncertainty of exchange rates, interest rate differentials, and leverage.  With 10:1 leverage, even a fractional move in the exchange rate could wipe out months or years of gains.
• The reward is collecting interest net of potential currency and interest rate fluctuations.

Free Carry-Out Lunch?

Investing where interest rates are high, to the exclusion of where they are low, might seem like a free lunch.  I distinctly recall my first years of trading, during the high-interest rate environment of the early 1980’s, where U.S. rates attracted massive inflows from around the globe.  For three years, anyone who owned the U.S. dollar (or, were receiving interest on its short-term instruments), while short almost any other currency on the globe made a tidy profit.  Not only did they earn a substantial interest differential, but the U.S. dollar persisted in appreciating as well.  It’s time like those that are etched into investors mind and yet fool our memories into thinking the “carry trade” is near riskless.

Carry Trade or Carried Away?

• 2007 – U.S. sub-prime mortgage crisis.
• 1998 – Japanese yen spikes 17.0% against the U.S dollar in just 4 trading days.
• 1997 – Thailand Baht collapse.
• 1994 – Mexico peso devaluation.
• 1991 – German Mark vs. European Continental currency crisis.

In recent years the U.S. dollar has been available at interest rates low enough to finance a carry trade into higher interest rate emerging market countries including – Brazil, Indonesia, and China.  These countries have enjoyed years of gradual yet steady U.S. dollar inflows which, on one hand, have offered the recipients (Brazil, Indonesia, and China) a cheap source of financing.  However, too much of this has the potential to quickly fill up dangerous air bubbles into the countries commodity, real estate, and equity markets.

China has become a high-yielding currency among the major currencies whereas, even after this week’s 4.0% devaluation versus the dollar, China’s interest rate differential remains comfortably wide. However, any combination of spiking U.S. interest rates, regulatory clampdowns,  or more CNY depreciation could trigger a vicious unwind – removing an important channel of cheap funding for the Chinese economy at the minimum while setting off worldwide panic as a maximum.

I don’t believe that this week’s action will trigger a major unwind nor is it necessarily a brewing currency war.  Rather, steady declines in Chinese GDP, Industrial Production, Retail Sales, Exports, and Housing Starts have incentivized regulators to devalue their currency precisely as they’ve reduced bank reserve requirements and implemented enormous infrastructure projects all in the name of economic management.

China knows that no amount of hard work and sacrifice will sustain a 7.0% pace in GDP growth.  At this point, it’s much more about smart, measured changes in currencies, rates, and the generosity of strangers (exports) that will keep their boom from going bust.