The Day The Carry Trade Died

I met a girl who sang the blues
And I asked her for some happy news
But she just smiled and turned away
I went down to the sacred store
Where I’d heard the music years before,

But the man there said the music wouldn’t play

D. McLean, 1971


The “Carry” of an asset is the return obtained from holding it [if positive], or the cost of holding it [if negative]. This is also called the cost of carry. A carry trade refers to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending [investing] in a high carry one.

One of the purest forms of carry trades has an FX linkage, whereby over recent years, for example, investors have borrowed money in USD, sold those USD to buy AUD, and then invested in AUD term deposits or government bonds, or bank shares. Adding even mild leverage of 5:1 transforms the nominal spread of say 4% into 20% returns. This trade has been tremendously important to global portfolio managers in recent years, driven into this arena as central bank monetary policy induced asset price distortion eradicated both yield and fundamentals from financial markets. This has been the clearest way to make money, with several non-interested high profile parties electing to close their funds (www.bloomberg.com). The best part of all, the Fed had been explicit in confirming it would not raise rates. A surprise rise in rates would have triggered a sharp spike in the currency on both a change in interest rate differentials and trade positioning. This is of course the achilles heel of the carry trade, why there is no free lunch, as market forces over time should cheapen the currency you have invested in and therefore make it relatively more expensive to pay back the borrowed funds. In FX parity models, your extra liability upon repayment amounts to the “positive carry” you have been earning during the duration of the trade.

Thus, it works until it doesn’t, another reason why it’s referred to as “picking up pennies off the railway track” – good for a while, but you don’t know how long … until the Fed entered the equation of course. So Fed Chair Yellen’s speech at Jackson Hole on August 22 gave a clear indication that they would continue to normalise rates, and confusion around this issue led to significant panic in the FX markets as investors sought to unwind their trades. The message is clear, the US carry trade is over.

The unwinding of these trades will continue to have profound implications for global markets. US equities have rallied to new all-time highs on the repatriated capital, but may come under pressure as the fixed income market there becomes more of a valid option in the coming 6-12 months. Our local sharemarket has had the shakeout of international players who have left unlikely to return, but our currency remains at the whim of the USD. We will continue to weaken in the short/medium term on both USD strength and local weakness due to a holding pattern of low rates [for longer than the US!] and Chinese/commodity proxy slowdown fears, but in the long term, well, only one of the currencies is being printed, and it’s not ours.