A New Millennium for Carry Trades

A New Millennium for Carry TradesIn the 2000s, the term "carry trade" became synonymous with the "yen carry trade", which involved borrowing in the Japanese yen and investing the proceeds in virtually any asset class that promised a higher rate of return. The Japanese yen became a favored currency for the borrowing part of the carry trade because of the near-zero interest rates in Japan for much of this period. By early 2007, it was estimated that about US $1 trillion had been invested in the yen carry trade. (For more on yen carry trades, see Profiting From Carry Trade Candidates.)Carry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. This was the case in the period from 2003 until the summer of 2007, when interest rates in a number of nations were at their lowest levels in decades, while demand surged for relatively risky assets such as commodities and emerging markets. The unusual appetite for risk during this period could be gauged by the abnormally low level of volatility in the U.S. stock market (as measured by the CBOE Volatility Index or VIX), as well as by the low risk premiums that investors were willing to accept (one measure of which was the historically low spreads of high-yield bonds and emerging market debt to U.S. government Treasuries). Carry trades work on the premise that changes in the financial environment will occur gradually, allowing the investor or speculator ample time to close out the trade and lock in profits. But if the environment changes abruptly, investors and speculators could be forced to close their carry trades as expeditiously as possible. Unfortunately, such a reversal of innumerable carry trades can have unexpected and potentially devastating consequences for the global economy.