As inflation hits multi-decade highs, some central banks are again aggressively raising interest rates, suggesting that carry trade could return from the dead in the coming months.
At the time, people used to joke that bankers followed the 3-6-3 rule: They borrowed money (deposits) from 3%loaned them (through mortgages and other loans) to 6%and were on the golf course by 3 o’clock in the afternoon.
While the banking sector has evolved considerably over the past few decades, the allure of relatively effortlessly earning an interest rate differential between the cost of money on borrowed funds and the return on lending that same money is timeless.
Enter FX carry trade.
What is the FX carry trade?
As we pointed out in our educational article on the subject, “A carry trade is a trading strategy that involves borrowing a low-yielding currency (low interest rate) to buy a higher-yielding currency (high interest rate) to take advantage of the interest rate difference .”
Before the Great Financial Crisis (GFC), it was one of the most popular FX trading strategies on the planet, with many traders selling currencies with lower interest rates, such as the Japanese yen, and buying currencies with relatively high interest rates, such as the Australian dollar or even more exotic emerging currencies like the Turkish lira. Even though the difference between the relevant rollover rates, say on the AUD/JPY, was only 2.00%, by incorporating leverage, traders were able to earn significant annualized interest rates. If the AUD/JPY exchange rate also increased, the carry would be even more profitable, although it should be pointed out that a drop in the exchange rate could offset any profit or even result in outright losses despite the positive carry.
Is the FX carry trade back?
The popularity of the FX carry trade was hit hard when most global central banks pushed interest rates to essentially 0% following the GFC, but As inflation hits multi-decade highs, some central banks are again aggressively raising interest rates, suggesting that carry trade could return from the dead in the coming months.
For example, traders expect the Federal Reserve to raise the target federal funds rate to nearly 2.00% by July and nearly 3.00% by the end of the year, while the BOJ continues to intervene aggressively in Japanese bond markets to ensure that interest rates on the 10-year JGB do not rise above 0.25%. In other words, the “spread” between the Fed and BOJ primary interest rates will likely exceed 2.00% in the second half of this yearoffering noticeable positive carry on a long USD/JPY position, especially considering the potential leverage effect on the trade.
As the chart below shows, many traders have already priced in the positive carry potential with the pair, and USD/JPY has reached around 1,500 pips in the past two months alone.
Source: TradingView, StoneX
For anyone considering placing a USD/JPY carry tradeit is essential to monitor the price development in the underlying exchange rateas a drop of just 2% (or around 250 pips in this case) could wipe out an entire year of interest, but as long as the pair remains well supported (or even rises further), the newly rediscovered potential for positive carry on the forex market can provide a tailwind when trading certain pairs.