SERIOUS MONEY:The primary culprit for an explosion in foreign exchange market is the return of the carry trade

EXUBERANCE HAS returned to the world’s financial markets, with investors and speculators learning little from the events of the past two years and returning to “business-as-usual” with many of the strategies that contributed to the build-up of imbalances in evidence once again. Nowhere is this more evident than in foreign exchange, the world’s most active market, where higher-yielding currencies such as the Australian dollar and the South African rand are in demand once again and have registered stunning gains against the dollar since the March low in asset prices.

Both the Australian dollar and the South African rand have appreciated by more than 30 per cent against the greenback in just seven months. Other currencies such as the New Zealand dollar have recorded even more spectacular gains. The primary culprit is the return of the carry trade.

What is a carry trade? It is a strategy that is based on exploiting the interest rate differentials that exist across countries and is widely employed by hedge funds and investment banks. The carry trade typically involves the use of leverage in order to enhance the returns available from the relatively low interest rate differentials.

The differential between short Australian and US rates is currently three percentage points, for example, but the minimal potential return can be magnified several times over through the use of borrowed funds in the cash market or by taking advantage of the low margin requirements in the derivatives market.

A carry trade can take many forms but, at its simplest, an investor borrows in a low interest rate currency such as the American dollar, converts the funds into a high interest rate currency such as the Australian dollar and lends the borrowed funds at the higher interest rate. In another version of the strategy, speculators take an outright position in the forward market in order to exploit the forward premium of one currency relative to another.

This involves selling currencies that are at a forward premium, where the forward exchange rate is higher than the spot rate, and buying currencies that are at a forward discount where the forward exchange rate is less than the spot rate. This strategy is equivalent to borrowing in a low interest rate currency and lending in a high interest rate currency.

The latter strategy is equivalent to the former due to an equilibrium condition of international financial markets known as “covered interest parity”. This states that the forward premium of one currency relative to another reflects the interest differential between the two countries.

High interest rate currencies are priced at a forward discount in the market and relatively low interest rate currencies are priced at a premium. Thus, borrowing in a low interest rate currency and lending in a high interest rate currency is the same as selling currencies that are at a forward premium and buying those that are at a discount.

The carry trade, however, should not yield predictable profits due to a further equilibrium condition known as “uncovered interest parity”. This condition states that the interest rate differential between the two currencies reflects the rate at which investors expect the high interest rate currency to depreciate relative to the low interest rate currency.

Thus, the strategy should yield zero profits as the movement in exchange rates equalises the returns in both currencies.

Although carry trades should not yield predictable profits, equilibrium conditions are consistently violated over short horizons in the foreign exchange market. Indeed, low interest rate currencies tend to depreciate while high interest rate currencies tend to appreciate, contrary to what international parity conditions predict.

This means that a carry-trade investor can expect to earn not only the interest rate differential between the two countries as reflected in the forward exchange rates but also the appreciation of the high interest rate currency.

Academic research reveals that carry trades have generated exceptional risk-adjusted returns over time. Indeed, a portfolio of carry trades that were continuously rolled over would have yielded investors stock-like returns with substantially less volatility since the late-1970s.

The carry trade is understandably popular in this context, though the strategy is not without risk and has been aptly likened to “picking up pennies in front of a steamroller”. The profitability of the strategy typically reverses rapidly following a change in fundamentals and those who do not unwind their positions quickly are left nursing large losses.

The persistent appreciation of high interest rate currencies as a result of strong investor demand has serious economic consequences that eventually precipitate a sudden and sometimes dramatic depreciation. The capital inflows induced by interest rate differentials drive exchange rates away from market equilibrium and the real appreciation of the high interest rate currency results in an erosion of competitiveness that shows up in a deteriorating current account position.

The fall-out from the unavoidable depreciation that follows hits not only the currency speculators but also banks and corporations that have borrowed in foreign low interest rate currencies and invested the funds in higher-yielding domestic assets. Indeed, carry-trade speculation has been a recurrent phenomenon in recent decades and has been associated with frequent banking and financial crises including Mexico in 1994, east Asia in 1997-1998, Russia in 1998, Brazil in 1999 and Argentina in 2001-2002.

More recently, large external balances and financially fragile conditions culminated in a banking and financial crisis for Iceland, a country with a formerly rapidly appreciating currency that one year ago was forced to call for IMF standby loans.

One year on and the carry-trade speculators are back, with high interest rate currencies enjoying outsized gains vis-à-vis the US. The trades have no regard for the underlying fundamentals so long as they do not upset an exchange rate’s established momentum.

The lessons learned from the worst economic and financial crises have been few and the seeds of the next crisis are already being sown.

charliefell@sequoia.ie