Many people don’t really get the “carry trade” strategy and why it’s so great. Their focus is on the daily interest and they don’t see themselves getting rich off of the daily interest. However, that’s only ONE of the reasons why traders get into the carry trade.
Think of a carry trade this way. Let’s say you have two banks in the same town. Bank A will offer you 3% in a savings account while Bank B will only offer you 1/2 of 1% (0.50%). Which one are you going to deposit money into?
Now, if you were a betting man or woman…which bank would you bet on having the most “inflows” of deposits? Of course, Bank A…because people aren’t idiots and want to earn the most they can on their money.
Well while the carry trade isn’t a “savings account” by any means…it works off of a similar principle.
Traders and investors alike want to earn the most that they can on their money. After all, the interest earned is the closest thing to a guarantee as you’ll get. So investors look out in the “investing arena” and look to see who has high interest rates when compared to others.
It’s no surprise that investors from all over the world pile into the same, few high yielding currencies.
Look at the chart below and you will see what investors all over the world are looking at. Now which currencies would you look into first? The U.S., Japan?….or Australia and New Zealand? Of course, the latter. Why? Because your mama didn’t raise a dummy and you want to get the highest interest rate possible on your money. Click on the charts below to enlarge them.
Guess what? So does everyone else out there in the world. So it’s no surprise that money flows away from the U.S. and Japan right now and into Australia and New Zealand. They’re moving their money from “low yields” to “high yields”.
So now that we can predict the “long term” flow of money…why not jump in the line now and allow all of the other future buyers of Aussie and New Zealand dollars push up our positions in these same currencies over time.
So if I buy any of these (as of the time of this writing): AUD/USD, AUD/JPY, NZD/USD or NZD/JPY then I can enjoy BOTH the money flow AWAY from the U.S. and Japan and the money flow INTO Australia and New Zealand. By capturing both dynamics…my positions ratchet higher over time WHILE at the same time, I’m earning DAILY interest while I wait for further appreciation in the pair.
When this strategy works: This strategy works when the global economy is coming out of a recession (past the trough of the recession) and in expansionary times when countries are doing good economically.
When the strategy doesn’t work: This strategy doesn’t work when the global economy is about to go into a recession (or for that matter, usually even when it’s just the U.S. going into a recession).
Since expansionary times last longer than recessionary times, the strategy works, more times than not.
When it’s not working….guess what? Short these pairs and you can make money that way.
Sean Hyman
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