Carry Trade On The Comeback Trail?

04/28/11 02:50:39 PM

by Matt Blackman

Back in the good old days before the financial crisis hit head-on, the financial media was rife with stories of how international players were winning big in the carry-trade game. That all changed when the meltdown came, but there are signs that the much-maligned strategy is back. Here is a brief carry-trade history.

Security: USD-ISK
Position: N/A

Iceland, the small North Atlantic island nation with a population of just over 300,000, is well known for its natural hot springs and magnificent volcanic displays. But before the financial crisis humbled the global economy, it was popular in financial capitals thanks to an interesting investment strategy called the carry-trade. In a nutshell, carry-traders, a club normally reserved for large investors with global banking connections, would borrow in low interest rate currencies and invest the proceeds in nations offering high-yielding investments. If all went well, investors would earn a generous premium between the cost and return of the investment.

Prior to 2008, Iceland had gained a reputation as an investment magnet. Interest rates were one big reason. The Icelandic central bank, which had become independent by law in 2001, had steadily increased the key overnight lending rate from 5.3% in 2003 in an attempt to stem inflationary pressure due to rising foreign direct investment and growing domestic demand. This rate hit 15.5% in 2008 in the months before the crisis hit full force.

FIGURE 1: LENDING RATE. Japanese overnight lending rate from July 2006 through April 2011. Even at the high of the financial crisis in 2008, the rate never rose above 0.5% compared to an overnight rate above 15% before the crisis in Iceland.

Graphic provided by: Bloomberg.

For the carry trade investor, this high interest rate meant they could borrow money from Japan at interest rates near zero, for example, and buy Iceland government bonds earning near or above double-digit returns.

But there was one risk, and that was the interest rate differential between the base currency (yen) and target currency (Icelandic krona). When the Icelandic economy finally overheated and imploded in October 2008, the krona collapsed. In a few short weeks, carry gains quickly turned into crushing losses.

FIGURE 2: USD-ISK, WEEKLY. Here's a chart of the USD-ISK (dollar-Icelandic krona) currency cross showing the huge spike as Iceland�s economy came undone in 2008.

Graphic provided by: http://www.genesisft.com.

However, as the global economy has slowly mended, carry-trade opportunities have resurged thanks to growing interest rate differentials between some large slow-to-recover economies and the more robust, reactive economies in commodity-based and emerging markets. Strategies can range from simple interest rate differential trades like the one discussed here, to borrowing and selling low-yield currencies to invest in stocks in fast-moving stock markets elsewhere.

I will be discussing some of these opportunities in more detail in an upcoming Working Money article entitled "Playing Through on the Carry-Trade."

Follow the stocks I'm watching on Twitter at http://www.twitter.com/Matt__Blackman (double underscore between "Matt" and "Blackman").

Suggested reading

Iceland's Financial Crisis In An International Perspective
http://goo.gl/qxozn

Great Inflation Debate (Part 2) - (see Problem 3 - Interest Rate Risk)
http://tradesystemguru.com/content/view/288/61/

Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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Carry Trade On The Comeback Trail?

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