There is a strategy called the “carry trade” which can be used by traders for profiting in the markets. The most popular carry trade is a strategy in which traders borrow a currency that has a low interest rate and use the funds to buy a different currency that is paying a higher interest. The carry trade was once described in Robin Hood terms as “borrowing from the rich to lend to the poor”. It can also be composed by investments in low grade bonds financed by borrowings in high grade bonds, investments in long maturity bonds financed by borrowings in short maturity bonds, and even options strategies, but the most well-known examples involve movements in currencies.
This move can affect different markets and that’s why you should be aware when it happens.
So, take the following scenario: First hedge funds borrow a low-interest currency like the JPY or the USD, for example, and apply those funds into higher-yielding currencies like the AUD, NZD or Mexican Peso. Then they borrow against these AUD, NZD or whatever high-yield currency they first applied the funds and go out and buy appreciating assets like stocks, gold, silver, oil, etc… They do this because they can make big returns and collect big fees.
This is important because when funds are putting on the carry trade, also known as “putting risk on”, then most asset classes rise in value. The reverse can also happen, when they are “taking risk off”, which means that they are first selling the assets they bought, second dumping the high-yield currency they own, and finally paying back the cheap currency they borrowed in first hand. Notice that the time lag in between these steps can be very short. So, when this “risk-off” takes place, forget the news, because nearly all asset classes will sell off.
A way of noticing these moves are by watching the charts behavior. Take the following example with AUDJPY and S&P500 in 2011:
AUDJPY and S&P500, Daily charts
The more yen that are being borrowed, the more AUD is being bought, and thus the higher AUDJPY goes, making the carry trade “on” (“putting risk on”). And when the carry trade is being taken off, AUDJPY will fall as Australian Dollars are sold to pay back the yen loans (“risk off”).
You can see on the graph above that point 1 and 2 shows a rising AUDJPY and a rising stock market. Point 3 and 4 shows a falling AUDJPY and a falling stock market. The interesting thing is that AUDJPY acted as a leading indicator in point 5. You can see that it broke out to new highs, while at the same time the stock market did practically nothing and even went down a little bit (at the time, due to solvency problems in European countries). However, AUDJPY kept rising higher and higher, and indeed, after some time, the stock market broke out and made new highs (Point 6), while the negative news continued to be played. The money that the funds borrowed had to be put to work.
This strategy can also serve as an indicator in intraday trading. In the following graphic, you can see again that while in S&P500 occurred a somewhat intense sell-off in the middle of the upward trend (Point 1), there was only a mild pullback in AUDJPY… So the odds of the S&P500 turning around and rallying were more favorable.
AUDJPY and S&P500, 5 minute chart
Finally, the carry trade can explain some movements that can be counter-intuitive at first. For example, during the 2008 financial crisis, many people were thinking that the USD was about to collapse and that the money should be put in gold and gold stocks, for safety. What happened was that during a huge “risk off” scenario, AUDJPY plummeted from 100 to below 60 and funds were forced to sell everything that counted as an asset, and that included gold. All the assets that funds had bought with borrowed money had to be sold so that they could pay back their loans. So the USD actually rallied during this period, since it was also used in the carry trade, along with the yen – paying back USD applies upward pressure on the USD.
Carry trade during the 2008 financial crisis – AUDJPY, S&P500, Gold, USD Daily charts
“Adventures in the Carry Trade”, John F. O. Bilson. July 30, 2013