It’s been a tough year for the euro, which has fallen to parity with the US dollar amid a dicey backdrop for the region. But it’s also boosted the potential of one particular trade that’s both shown strong returns – as much as 29% this year – and low correlation with traditional asset classes. So here’s how this “carry trade” works exactly, and how you can replicate it yourself.
What is a carry trade?
A carry trade involves buying higher-yielding currencies by borrowing funds in lower-yielding currencies. In practice, that means buying those with high interest rates and selling those with lower rates. The rationale is that the returns from the former tend to outweigh the latter in the medium term, when you factor in both currency price moves and the income earned from the difference in interest rates.
This particular carry trade involves buying EM currencies by selling the euro, and there are a couple of reasons it’s worked so well. First, the European Central Bank’s (ECB’s) main interest rate was negative until last month, while many EMs’ interest rates – already relatively high at the start of the year – have only been rising. That’s offered a widening interest rate differential for carry traders to pocket.
Second, the euro has fallen in value relative to 18 of the 23 currencies tracked by Bloomberg since the start of the year. So traders who have sold the euro have profited as its value has dropped. Compare that to the US dollar, which has gone from strength to strength, and you might be able to see why this trade has outperformed the same one involving the US dollar by quite some margin.
EM currencies' year-to-date carry return vs. the euro and dollar. Source: Bloomberg
What’s more, market players are betting that the trade will stay profitable for at least the rest of the year. With the eurozone on the brink of recession, the ECB won’t be in a position to aggressively raise interest rates. That means the gap in interest rates between EMs and the continent isn’t likely to shrink, which also dampens the outlook for the euro.
What are the risks?
As always, just because the carry trade has worked well in the past doesn’t mean it’ll continue to do so in the future. And since carry trades – especially the more profitable ones – tend to be overcrowded, the strategy can crash hard during times of market stress as traders rush to the exit all at once.
EM currencies can also be quite volatile. Economic issues in the regions have a history of spiraling out of control, which can lead to big collapses in currency values. So whatever interest rate differentials carry traders were pocketing, they stand to lose all of that – and more – if an EM currency collapses in value. There also can be a contagion effect: economic crises in EMs have a history of spreading well beyond their starting points, causing many of the currencies to fall at the same time.
Finally, FX trading is often done using leverage: you stump up a small amount of capital which is then magnified on your behalf. That amplifies your potential for gains, but it also means small currency movements in the wrong direction can lead to big losses. If you do decide to trade on leverage, use it sparingly.
So how do you implement the carry trade?
1. Use Global-Rates.com to see the latest interest rates set by the world’s central banks. The EMs on the Global-Rates website are Saudi Arabia, China, India, South Africa, Indonesia, Poland, Czech Republic, Mexico, Russia, Chile, Hungary, Brazil, and Turkey.
2. Pick the top four EMs with the highest interest rates. Right now, that’s Turkey, Brazil, Hungary, and Chile.
3. Buy those four EM countries’ currencies against the euro. For example, you’d buy BRL/EUR, which means you're buying the Brazilian real and selling the euro. You’ll want to allocate an equal amount to each currency pair: spreading your bets reduces the risk of big losses if one of them falls heavily in value.
Every day you hold the trade, your FX broker will deposit the difference in interest rates between the currencies through a mechanism called “rollover”. And as an added bonus, higher-yielding currencies tend to go up in value relative to lower-yielding ones, as more investors flock to them to benefit from the higher interest rates.
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