What is a Carry Trade and why has it inverted?

Think of a currency carry trade in terms of two opposite positions - selling a low interest rate currency called the “funding currency” and investing that money in a high interest rate currency, the “investment currency.”

This doesn’t make sense because hey, what about uncovered interest parity (UIP)? If an interest rate differential between two currencies exists, the exchange rate movements should wipe it out. Which is to say that the investment currency should depreciate??

Well, that almost never happens. That’s the ‘forward premium puzzle’ - high interest rate currencies in fact tend to appreciate against low interest rate currencies.?

Bad news - it flies in the face of textbook economics, but good news - it keeps the carry trade profitable.?

Note that this is no easy business - someone went so far as to say “Trading currency carry trades is like picking up nickels in front of steamrollers: you have a long run of small gains but eventually get squashed”?

An increase in the VIX volatility index has coincided with unwinding of the carry trades. The trade thrives in a low-volatility environment - when you’re not expecting sudden stops anytime soon.

A popular currency pair in the trade has been AUD/JPY. You borrow the Japanese Yen and you park that into high-yielding Australian dollars. For the most part since 2008, this trade has made sense because Japanese interest rates have been low (sub zero) and Australian interest rates have been much higher.?

(These conditions start to change around 2008 if you look at the chart)

But concerns that the carry trade may no longer be the money machine started to surface in 2023.?

Now the Fed's higher for longer monetary policy seems to have flipped the trade on its head. As some developing economies struggle to keep their yields competitive with the US, we’re now seeing what looks like a "reverse carry trade" - borrowing low-yielding emerging market currencies and buying the dollar instead.?

Currencies like the Chinese yuan, Thai baht, Malaysian ringgit, and even Czech koruna have become targets of this reverse carry trade, generating returns as high as 9% this year for traders buying the greenback with them.?

While the traditional carry trade using the Mexican peso, Turkish lira and others still exists, it's increasingly being funded by the Japanese yen, Swiss franc or other EM currencies rather than the dollar.

A trader could borrow Thai baht at 1.25% to buy higher-yielding US dollars earning around 5% currently, pocketing the difference as profit after covering borrowing costs. What's driving this reversal??

Two key factors - currency moves and shrinking yield differentials. The robust US economy has kept the dollar stubbornly strong, depreciating 29 of 32 major EM currencies in 2023.?

Meanwhile, at least 11 emerging nations now have benchmark rates below the Fed's, erasing the former yield advantage that attracted carry traders.?

While a hawkish pivot from emerging markets could revive the traditional carry trade if Fed easing expectations hold, opinions are divided on the currency outlook. Some see EM currencies rebounding, but some banks expects the dollar's outperformance to persist as consumption-led US demand isn't filtering through to boost EM growth and currencies.?

For now, the reverse carry trade taking the other side looks like the surer bet.