• ‍Is Carry Trade "Bread and Butter": Carry trades profit from interest rate differentials by borrowing in low-interest-rate currencies to invest in higher-yielding assets, but the strategy's reliance on leverage makes it highly sensitive to market conditions‍
• Historical Lessons: The Turkish lira/dollar, USD/JPY and Brazil Real/dollar carry trade crashes highlight the risks behind carry‍
• Economic Risks: Economic changes, like unexpected data or recession fears, can trigger rapid unwinding of carry trades, as seen with recent yen appreciation after weaker US payroll data‍
• Policy Risks: Central bank policies, such as unexpected rate hikes like the Bank of Japan’s recent move, can reduce carry trade profitability by narrowing interest rate differentials‍
• Liquidity and Volatility Risks: Carry trades are vulnerable in illiquid and volatile markets, where forced sales and market volatility can quickly turn gains into losses‍
• Risk Management Strategies: Mitigating risks in carry trades requires effective portfolio management, including diversification, hedging, maintaining liquidity, and disciplined leverage management

In late February, Tokyo’s financial district was a hub of palpable optimism. Tokyo’s dealing department even opened its doors to the media, offering an exclusive glimpse into the normally inaccessible heart of its trading floor. This was no ordinary occasion—the Nikkei 225 was during a historic surge, on the cusp of surpassing its 1989 all-time high, a peak reached during the apex of one of the largest asset bubbles in financial history. It appeared that Japan was once again on a trajectory towards sustained economic recovery.

However, the euphoria was short-lived. Last Monday (5 August 2024), the market's momentum dramatically shifted. The Nikkei 225 index plummeted by 12.4% as the yen appreciated sharply against the dollar. This reversal was driven by a combination of heightened risk aversion due to growing concerns about a potential U.S. recession and a more hawkish stance from the Bank of Japan. The consequent unwinding of carry trades further strengthened the yen, pushing it to 141.7, its highest level in six months.

Is Carry Trade “Bread and Butter”?

Carry trade is an investment strategy where investors borrow in a low-interest-rate currency to invest in higher-yielding assets abroad. By taking on spot risk, they aim to profit from the interest rate differential while hoping the depreciation of the borrowed currency. This approach allows investors to benefit from paying lower interest on the borrowed currency while earning a higher yield on the invested capital abroad.

In the context of Japan, this strategy typically involves borrowing low-yield yen due to the Bank of Japan's zero-interest-rate policy, and converting it into U.S. dollars to capitalize on the near 5% interest rate differential. The underlying assumption is that the yen's depreciation against the dollar will not exceed the interest rate advantage over a year. Since the Federal Reserve began its rate hikes in 2022, the USD/JPY carry trade has become increasingly attractive, leading to substantial capital outflows from Japan, keeping the yen weak and the stock market buoyant.

Following last Monday’s dramatic collapse in the Japanese stock market, the concept of carry trade has undoubtedly captured your attention, with hot headlines. Rather than reiterating what you’ve already learned, I’d like to shift our focus to the underlying risks associated with this strategy and the crucial importance of managing these risks effectively within your portfolio.

The most recognized form of carry trade is the currency carry trade, as exemplified by the dollar-yen pairing. In the currency markets, we distinguish between low-interest-rate "funding currencies," which are borrowed to finance carry trades, and high-interest-rate "recipient currencies," which attract investment due to their attractive yields. While currency carry trades often deliver positive returns over time, driven by capital inflows that support and even appreciate the recipient currency, this success runs counter to traditional economic models. Consequently, carry traders not only profit from the interest rate differential but also from currency appreciation, resulting in robust overall returns.

At first glance, the profits from carry trades might seem like a reliable "bread and butter" strategy. However, it’s crucial to recognize that these returns are far from risk-free. Academic research indicates that the gains from carry trades are not a "free lunch," but compensation for taking on specific financial risks.

Historical Lessons

Historically, when the currency of a carry trade recipient begins to depreciate, investor aversion to that currency intensifies. This depreciation typically coincides with local economic downturns and financial crises. Turkey over the past decade serves as a textbook example of this dynamic. With persistently high interest rates, Turkey attracted foreign investors and speculators who bought Turkish debt for its high yields, while Turkish companies and individuals borrowed in dollars due to the lower U.S. interest rates. The resulting capital inflow fueled economic growth and elevated inflation, fostering a sense of complacency among investors and leading to an increase in carry trade activity.

However, this complacency was shattered by the Turkish economic crisis of 2018. The excessive current account deficit and substantial foreign currency debt made the Turkish economy vulnerable, leading to a sharp crash. The Turkish lira plummeted in value, inflation soared, and borrowing costs surged. The once-stable economic and exchange rate environment quickly gave way to heightened risk aversion, causing a dramatic contraction in credit demand. Investors, in a panic, unwound their carry trades to mitigate losses from the lira's depreciation. As depicted in the chart below, the sharp decline in net claims on Turkey—representing the difference between capital inflows and outflows, primarily driven by investor concerns over Turkey's monetary policy, rising inflation, and the central bank’s perceived lack of independence — serves as a clear indicator of the unraveling of carry trades in 2018 and again in 2021.

We must not underestimate the impact of risk aversion, as markets have a tendency to amplify economic downturns and overreact to unwind positions and cover losses. A striking example was the dramatic surge in the yen in early October 1998, during the aftermath of the Asian and Russian financial crises and the collapse of the hedge fund giant Long-Term Capital Management (LTCM). Over the course of October 7–8, the dollar plummeted nearly 15 percent against the yen, with much of this rapid appreciation occurring during London’s lunchtime hours—just as the U.S. markets were beginning to trade. The yen’s swift and unprecedented movement, where it gained several "big figures" within minutes, serves as a powerful reminder of the volatility inherent in carry trades. While these strategies can yield profits over extended periods, they also carry the risk of seeing those gains evaporate almost overnight.

Risks behind Carry

The tapestry of historical lessons clearly illustrates that carry trade, as an investment strategy, fundamentally relies on leverage—borrowing capital in low-yielding local markets to seek absolute returns in foreign markets that rival traditional asset classes. However, the inherent use of leverage amplifies the stakes; even slight shifts in market conditions can lead to significant capital losses. This underscores the critical importance of vigilant risk management. The risks associated are encompassing economic risk, policy risk, liquidity risk, and volatility risk.

Economic Risk

Historically, carry trade crashes often manifest as financial crises for the recipient country, leading to sharp currency depreciation and a panicked sell-off of risk assets as investors scramble to cover their leveraged positions. When economic conditions shift unexpectedly—such as through a sudden slowdown in growth—the consequences can be both swift and severe. A recent illustration of this is last Monday’s weaker-than-expected U.S. non-farm payroll data, which heightened fears of a potential U.S. recession and precipitated a rapid weakening of the dollar. This, in turn, triggered the unwinding of carry trades that had built up over the past decade (As shown in below picture), as investors rushed to mitigate losses from the dollar’s decline. The forced repurchase of yen further strengthened the currency, deepening the losses and creating a vicious cycle that can quickly transform a previously profitable strategy into significant financial turmoil.

‍Policy Risk

Given that the profits from carry trades largely stem from interest rate differentials, and considering that central bank interest rate policies are a primary lever for influencing aggregate credit demand and exchange rates, it is imperative to closely monitor these policies and make precise forecasts. Last Monday's developments offer a pertinent example: the Bank of Japan (BOJ) unexpectedly adopted a more hawkish stance than the expectation from market, raising rates by 15 basis points and breaking away from the zero-interest-rate policy that had been in place since the 1990s. Simultaneously, concerns over a potential hard landing in the U.S. economy are narrowing the interest rate spread between the U.S. and Japan. This shift diminishes the appeal of carry trades, leading to a weaker dollar and a sudden surge in yen strength (As shown in below picture), underscoring the importance of accurately predicting interest rate movements in managing carry trade risks.

Liquidity Risk

Given the inherent leverage in carry trades, the potential for a “bank-run” dynamic is alarmingly high. Losses prompt position reductions, compelling investors to trade into adverse markets, often exacerbated by the illiquidity of many emerging currencies. This activity accelerates further losses, necessitating even more position reductions, creating a vicious cycle that continues until exchange rate movements become so extreme that either unlevered traders are enticed to enter the market or central banks are forced to intervene to restore stability. With carry trades now more leveraged than ever, we can anticipate that future carry crashes will unfold with even greater intensity, particularly in emerging markets, which are the primary recipients of carry trade flows.

Brazil’s experience over the past few years exemplifies this pattern. As a major recipient of carry trade flows, Brazil was especially vulnerable to this dynamic. The Brazilian real began to depreciate against the dollar in late 2014, a decline that quickly escalated into a collapse. Within just two months in early 2015, the real lost over 20 percent of its value against the dollar, and it fell again by more than 25 percent during a similar period that summer. As carry trades increasingly influence credit creation, we can expect that future carry crashes will trigger more severe downturns in the real economy than we have witnessed in the past.

Volatility Risk

Carry strategies inherently operate as short volatility trades, meaning that they thrive in stable market conditions but face significant risks during periods of heightened volatility—typically during financial crises. When exchange rates remain stable, carry trades are designed to generate consistent profits. However, like all short volatility portfolios, these strategies are most profitable when markets are calm and “nothing happens.” Conversely, periods of increased volatility can be disastrous for carry trades, leading to substantial losses at the most inopportune times.

The accompanying chart illustrates this dynamic, showing the median return of carry trades across the median change in U.S. stock market implied volatility, as measured by the CBOE’s VXO index. The data reveals that the worst-performing months for carry trades (Decile 10) coincide with sharp spikes in stock market volatility. On the other hand, the most profitable carry trade outcomes are typically linked to a decrease in volatility.

The Guardian of Carry Strategies — Portfolio and Risk Management

Having walked through these risks, you might be wondering: is the carry trade still a safe haven, or does it make you want to run for the hills? So, what’s the plan? Do we unwind all the carry trades we’ve built since 2022, or just trim some of the earlier ones? The answer largely depends on the current risk environment and your comfort level with the positions in your portfolio. This is where effective portfolio and risk management come into play—they are essential for navigating the complexities and inherent risks of carry trades, helping you make informed decisions that align with your financial goals.

Firstly, to manage these risks, several strategies can be employed. Diversification is a fundamental approach, spreading investments across multiple asset classes and markets to reduce the impact of adverse movements in any single asset and the use of structured products could provide the downside protection or participate the asset surge with fully invested capital redemption. Additionally, hedging strategies, such as using options or forward contracts, can protect against unfavorable currency fluctuations by locking in exchange rates or providing downside protection.

Secondly, monitoring macroeconomic indicators and central bank policies is essential for timely adjustments to carry trade positions in response to potential market volatility. Utilizing Swiss francs (CHF) to finance dollar carry trades has long been a favored strategy among investors, but this necessitates close scrutiny of the economic data and interest rate policies of both nations to flexibly adjust trading strategies.

For instance, if we believe that the market has overreacted to the significantly lower-than-expected July non-farm payroll data—primarily due to a reduction in temporary workers during the summer and layoffs induced by Hurricane Beryl, which temporarily increased unemployment—then we anticipate that the non-farm payroll data in August and September will rebound as these workers are rehired. This would bolster the dollar against the franc, thereby yielding profits from the carry trade. Conversely, if geopolitical risks in the Middle East escalate, the franc, as a safe-haven currency, is likely to appreciate. Faced with such dual forces, investors must promptly adjust their positions according to market dynamics to balance risk and return.

Furthermore, ensuring adequate liquidity within the portfolio is crucial, particularly when navigating carry trades in emerging markets. This liquidity allows for swift reallocation of assets in response to market shifts, thereby avoiding forced sales in illiquid environments. It's also imperative to closely monitor margin levels and adjust positions proactively to prevent overdrafts amid currency fluctuations.

Finally, exercising disciplined leverage—or strategically reducing it—can significantly mitigate the amplifying effects of market volatility, thereby reducing the risk of catastrophic losses during periods of financial stress.