Hidden Dangers Befalling Carry Trade Strategy

What is the carry trade? In what seems like a game with little risk, one can borrow dollars for next to nothing and plough them into other assets. The low interest rate “carry” and the eventual rollover of assets can result in large profits. For example, you could borrow one million dollars at the low interest rate of 1% featuring a carrying cost of just $10,000.

You could then decide to invest that capital into an asset class with a higher yield (say 6%), earning yourself $60,000. As a result of the interest rate spread between the two, you would earn a tidy $50,000 with just a keystroke. At 10 to 1 leverage, you could earn $500,000 for the trade.

The dollar, because of low interest rates, is increasingly becoming a vehicle for the carry trade. Global bankers borrow the dollar while investing in higher dividend paying currencies pocketing the differences.

Their bet is that domestic deficit spending policies and Federal Reserve policies geared to help an ailing economy will keep the dollar interest rate low and make the trade profitable long term.

Japan has for the last 20 years fostered a near zero interest rate zone for the Yen. This currency depressing policy has resulted in near zero growth for their economy.

Yen Carry Trade Example: To initiate a Yen trade, the trader will buy a currency with a stronger economy and selling the currency with a weaker economy. Some currency pairs that are usually selected to apply the carry trade strategy are: GBP/JPY, GBP/CHF. The trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison.

Unravel Risk: Everyone will have to close their shorts on the dollar if the trade falls apart. This will cause those assets that were invested elsewhere to be liquidated. On a worldwide basis, panic in order to cover those short can cause severe financial angst. Which in turn may cause severe “asset busts” if the bubble is big enough and cause major economic disruptions. The crash can be as big as the asset bubble buildup.

Consider what would happen if panic results. In the era of cradle-to-grave promises, when money owed came due, they would just keep printing more money. It worked to stem the banking crisis. It worked to stem the banking crisis. However, sooner or later a sovereign debt crisis in the West will reach a critical stage and the ensuing financial earthquake will shake all financial arenas.

The carry trade strategy finds one borrowing a currency at low interest rate and invest in a currency with a higher rate. Paying attention and on top of market and world events, one can avert large down draws. Get informed to the changing economic tide by a subscription Investors Business Daily.