It’s often said there is more than one way to skin a cat, a concept that forex traders are all too familiar with. Over the last few decades, speculators have feverishly gone down rabbit holes, so to speak, looking for the most low-effort and foolproof strategies for beating the market.
One of these methods is the carry trade or carry trading, an intriguing and passive way of earning daily interest. Carry trading could be something to consider if you’re a position or long-term trader with a trading account that has a few zeros in it.
Yet, despite its existence, this strategy has become far less attractive than it used to be before 2010. While an alternative exists where it could be worth the risk, it’s still just as challenging.
What is carry trading in forex?
Carry trading is a strategy for exploiting positive swaps by buying a currency with a higher-yield interest against another with a lower-yield interest rate. The idea is that the daily- accumulating interest will produce a sizable profit even if the pair’s price goes against a trader’s position in the short term.
Interest rates are some of the fundamental drivers in determining a currency’s value appreciation or depreciation relative to another. Investors are constantly looking for countries with attractive interest numbers to gain a decent return.
However, such rates are also integral to the extent of swaps or rollover. At its core, forex trading is leveraged. We use borrowed capital from a broker to increase our profit potential significantly far higher than if we simply bought the physical currencies.
Therefore, using leverage is a form of a loan. Yet, unlike traditional credit, traders only pay interest if they’ve held their position/s overnight. The other unique element is, depending on whether you’ve taken a long or short order, one can alternatively earn interest each day indefinitely until they close their trades.
Carry traders stay abreast of the latest interest rate changes in the most popularly traded currencies such as the US dollar, British pound, euro, Swiss franc, and Japanese yen.
Such individuals look for positive differentials; the higher, the better. For instance, if you bought a currency with an interest rate of 5% while selling one with a 2% interest rate, the differential is 3%.
Unfortunately, these divergences have become gradually thinner over the years, representing the biggest downside to carry trading.
The adverse effects of increasingly lower interest rates
The 2008 global recession was arguably the turning point in the behavior of central banks in many developed countries. It was rare for valuable nations to have interest rates near zero or even minus before this period.
Additionally, we could argue that volatility was more stable than presently. However, after the financial crisis, central banks predominantly in North America and Europe have kept their rates quite low (almost on par with the Bank of Japan and Swiss National Bank) to stimulate their economies.
Another trend worth noting is that many central banks rarely go on a rate-hiking cycle nowadays. Therefore, even when the figures change, it is a tiny variance, if at all.
The chart below shows the interesting downtrend of how central banks from Australia, Canada, New Zealand, United Kingdom, United States, Japan, and Switzerland have lowered their interest rates after 2008.
The dovish behavior (cutting rates) of central banks has continued further with 2020’s global economic depression spurred on primarily by the Covid-19 pandemic. So, what does this all mean?
Finding exploitable carry trading opportunities has become much harder. Yet, some believe a light at the end of the tunnel exists with exotic markets.
Light at the end of the tunnel?
Exotic pairs involve markets that are not any of the major currencies (AUD, CAD, CHF, EUR, GBP, JPY, NZD, and USD).
These are typically from so-called emerging or developing nations like Mexico (MXN), Turkey (TRY), Argentina (ARS), Russia (RUB), and South Africa (ZAR), whose currencies are paired with other countries in the G20.
Unlike their established counterparts, such countries have higher interest rates to attract foreign investment. This means you can find notable differentials.
Case in point, Russia’s current interest rate is 20%, which is 40 times higher than the Fed’s (United States); Australia, Japan, and Switzerland have rates of 0.1%, -0.1%, and -0.75%, respectively.
Therefore, position traders will explore these to find optimal conditions in buying markets like TRY, RUB, and ZAR while selling some of the major currencies. However, exotic pair carry trading still carries some significant dangers:
- Exotic markets are much more volatile than major and minor/cross pairs. Of course, this can be advantageous if you’ve executed the correct position at the right time. However, it can certainly work against your favor as well.
- While some developing countries have higher rates, their economies are less valuable. This means that their currencies are naturally weaker compared to their dominant counterparts.
For example, the Turkish lira has been one of the weakest globally against all major currencies. So, while selling USDTRY or GBPTRY will provide a positive swap, you may actually be at a loss since the price would be unfavorable to that position. Therefore, you’d have to pray the trade didn’t go against you wildly.
As with any carry trade strategy, the main challenge is fluctuation variances. Ideally, you want to profit from the natural price appreciation or depreciation rather than from the swaps alone. This means using a larger stop to ‘stomach’ any possible fluctuations in the short term.
The fundamental challenge with carry trading is that the forex market doesn’t behave like a typical buy-and-hold investment. For instance, you can buy a newly-listed stock or even cryptocurrency. If everything went in your favor, it could move up with a few pullbacks.
One will rarely see these types of movements in a forex pair because we deal with currencies that fluctuate by their very nature. Thus, when you’re holding a position for an unusually long period, you should expect times when the price goes against it.
The main takeaway is that carry trading isn’t as viable as it once was before the 2008 global financial crisis. However, knowledgeable and experienced traders could still use it as a secondary strategy assuming they’ve conducted proper homework and understand the fluctuation risks.