Why is the carry trade so dangerous?

A retreat from the yen carry trade was partly behind May's massive global sell-off in stock markets and other assets. But the trade has returned with a vengeance - and so has the risk of another sell-off, says Cris Sholto Heaton.

Update: read The carry trade: a tsunami in the making for more insight into the risks facing the carry trade.

This feature is part of our FREE daily Money Morning email.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Few people can resist the lure of free money. Hence the recent fad for stoozing'; borrowing large sums on credit cards with a 0% interest rate and investing the proceeds in a savings account.

Without having to advance a penny of their own money, the borrower can pocket a few hundred pounds a year in interest. When the credit card's zero-rate period comes to an end, the borrower pays back the loan or, even better, rolls the debt over on to a new card. At one point a couple of years ago this trick was so popular that personal finance pages filled up with tips on how to do it.

Advertisement
Advertisement - Article continues below

Stoozing has gone out of favour somewhat since most credit cards began charging a balance transfer fee, making the returns less attractive (although you can still net 2%-3% a year from it). But the grown-up version of this trick hasn't vanished; indeed, it continues to power asset markets around the world. And that may be storing up serious trouble for the future

Of course, in institutional circles, stoozing goes by the more respectable name of the carry trade. But the principle is the same; borrow money at a cheaper rate than you can earn on an investment elsewhere, then sit back and enjoy the profits.

The big difference is that carry trades are a lot more dangerous than stoozing. Firstly, rather than being invested in a safe savings account, the money increasingly flows into riskier place, such as emerging market assets. Secondly, carry trades are often cross-currency carry trades, which carry extra risks

In a currency carry trade, the speculator borrows money in a low-interest rate currency and buys higher-yielding assets in a different currency. Today, the low-rate currency is generally the Japanese yen; the higher-yielding assets are often US dollar bonds, but sometimes more esoteric assets such as Icelandic housing bonds or even emerging market equities or commodities.

The carry trade is appealing because of the type of returns it can earn, particularly if the proceeds are invested in bonds. These returns may not be huge, but they're steady and consistent, and so they appeal to money managers who want a steady income stream for example, hedge fund managers with pension fund investors.

But the counterpoint to these small, steady returns is the possibility of a very large, very sudden loss. The biggest risk is generally that the exchange rate moves against you the higher-interest rate currency rapidly devalues, reducing the value of your assets relative to your borrowing. That's why these trades are often described as "picking up nickels in front of a steamroller"

Advertisement
Advertisement - Article continues below

We saw a good example of this earlier this year. The yen bounced sharply against the dollar in April as the Bank of Japan tightened the money supply; in response, many carry trade speculators bailed out of their assets to repay their yen debts. The knock-on effects from this were at least partly responsible for the global sell-off in May.

Since then the yen has fallen back and the carry trade has returned with a vengeance. Speculators now believe that the Bank of Japan is likely to let the yen fall further, in order to help its exporters. That reassures them that they're unlikely to be hit by a rising yen; in fact, they believe they'll benefit from a falling yen (which reduces the cost of their debt relative to their assets).

But there's something that they and all other investors should bear in mind. Firstly, when the yen rebounds against the dollar, it often snaps back very fast. A graph of the yen/dollar exchange rate shows very rapid bounces that are equal to or bigger than the April's rally in almost every year for the past decade. It also tends to hold onto those gains for a while. So carry trades can go from profit to loss with almost no warning.

Secondly, many asset prices now seem to be extremely dependent on the glut of cheap liquidity that comes from the yen carry trade; if you look a chart of the yen/dollar exchange rate against the MSCI emerging markets index this year, the correlation between the two is very striking. The implication is that if the yen rises and carry traders bail out of their assets again, we'll probably see another sharp global sell-off in all assets.

So what might cause the carry trade to unwind? Dresdner Kleinwort strategist Albert Edwards identifies one route. Plenty of carry trade money has flowed into risky cyclical assets. As we head into the economic slowdown, these assets are likely to fall in value. As a result, speculators in them will cut their losses, bail out and repay their yen debts.

This flow of money back into yen could boost the yen's exchange rate, regardless of the BoJ's desire to keep the yen cheap to help its exporters. A rising yen would put other carry traders' positions under water, causing them to sell off and head back into yen, and so on in a vicious circle.

Advertisement
Advertisement - Article continues below

This scenario seems highly plausible and, as we saw in April, it would have severe consequences for all assets. In Edwards' words, the "unstoppable force" of cheap yen is about to hit the "immovable object" of the economic slowdown. "Whiplash is likely in the months ahead."

Advertisement

Recommended

Visit/currencies/600640/the-currencies-to-bet-on-this-year
Currencies

The currencies to bet on this year

The US dollar could be set to weaken this year, while the euro, Canadian dollar and the Swiss franc could be good bets for optimistic traders.
17 Jan 2020
Visit/506272/welcome-to-currency-corner-your-weekly-guide-to-the-worlds-biggest-market
Currencies

Welcome to Currency Corner – your weekly guide to the world’s biggest market

Forex is by far and away the biggest market in the world, with an average daily trading volume of over $5trn per day. Here, Dominic Frisby looks at th…
3 May 2019
Visit/502761/the-nature-of-money
Currencies

The nature of money

The best currencies are based on a strong democracy, strong institutions and a firm attachment to both the rule of law and the protection of private p…
28 Feb 2019

Most Popular

Visit/economy/600632/money-minute-friday-17-january-uk-weakness-likely-to-continue
Economy

Money Minute Friday 17 January: UK weakness likely to continue

Today's Money Minute previews UK retail sales figures the UK, inflation data from Europe and industrial production from the US.
17 Jan 2020
Visit/520525/currency-corner-how-high-can-the-pound-go-against-the-euro-in-2020
Currencies

Currency Corner: how high can the pound go against the euro in 2020?

In the month in which we should finally leave the European Union, Dominic Frisby takes a look at the pound vs the euro and asks just how high sterling…
13 Jan 2020
Visit/investments/property/house-prices/600638/uk-house-prices-may-be-heading-for-a-boris-bounce
House prices

UK house prices may be heading for a Boris bounce

The latest survey of estate agents and surveyors from the Royal Institution of Chartered Surveyors is "unambiguously positive" – suggesting house pric…
16 Jan 2020
Visit/investments/stocks-and-shares/share-tips/600636/class-acts-going-cheap-buy-into-europes-best
Share tips

Class acts going cheap: buy into Europe’s best bargains

Value investing appears to be making a comeback, while shares on this side of the Atlantic are more appealing on metrics such as price/earnings ratios…
16 Jan 2020