Can A Carry Trade Work Well As Interest Rates Rise?

If you want to secure Forex funding, the first thing you will need is a viable strategy that has a serious prospect of success. In various times and situations, some might be more reliable than others.

For instance, hedging may be very risky at present for those basing their expectations on the economic consequences of what may happen next in the Russia-Ukraine war. As we have seen, the impact on energy prices and connected costs – especially food – has been high, all of which have had a range of wider economic consequences that include tighter monetary policies to fight inflation.

In that instance, given the uncertainty of how the Ukrainian counter-offensive will pan out and the difficulty of predicting whether the war will drag on, see a swift conclusion or even a negotiated settlement, any strategy based on related assumptions will be risky.

Other geopolitically-contingent issues may also impact markets. China’s sabre-rattling over Taiwan may be nothing more than that, but nobody can be sure.

Equally, trades based on future national economic policies and their impact on currency values may be uncertain; the UK, for example, may be 18 months away from a change of government, but the details of all that will mean for economic policy are yet to be fully fleshed out, especially as it is unclear whether a new government will have a single-party majority or not.

Cash and Carry

However, there may be other strategies that are far sounder, with one emerging possibility being that of a carry trade. This is where you make a tidy profit on a trade between two currencies in which one has much higher interest rates than another. This differential – the interest rate spread – means some currencies offer much higher yields.

The way you make money on this is through buying the currency with the higher rate (from which you can benefit from the higher interest accrued), with the purchase being funded by shorting the currency with the lower rate.

Typically, examples of this – such as in the definition given by Investopedia – feature the Japanese Yen as the currency with the very low rate. This is because the Land of the Rising Sun is not the land of rising inflation; indeed, it has often slipped into deflation. Thus minimal interest rates were normal there long before the 2007-09 financial crisis made them common in the West.

Japanese Exceptionalism

Japanese Yen banknote

Even last year, the World Economic Forum (WEF) observed that the gap between Japanese rates and those elsewhere was widening, which has continued as central banks across the West, not least the Bank of England, have continued to tighten monetary policy.

The WEF observation was that the Japanese approach of monetary loosening was curious at a time when inflation was at its highest in decades, albeit still just 2.8 per cent. However, even if Japan tightens up, there is still a significant gap with the rest.

However, it may also be asked whether it is possible to do a carry trade using currencies other than the Yen. Few might have considered that could be the case using currencies like the Euro and Sterling, but much has changed in the last few months.

Britain Beats The Forecasters

On the one hand, various prophecies of a recession in the UK have proved unfounded, with organisations such as the International Monetary Fund now declaring Britain will not suffer a recession in 2023, a far cry from previous forecasts that the country would be in a shallow recession all year long. By contrast, the Eurozone has now gone into recession.

That may bring better tidings for the UK than some of its neighbours, but it also has implications for interest rates. A recession may prompt the European Central Bank (ECB) to limit its base rate rises and prompt a cut sooner than might have been expected previously. The reverse could apply in the UK.

It is not just that the UK base rate is now 4.5 per cent; while so much of the inflation in the British economy was the result of the shock generated by events in Ukraine, recent statements by Bank of England Monetary Policy Committee members have made clear that much of the upward pressure is now generated domestically, making the Ukraine situation less relevant.

For example, last month the Bank’s governor Andrew Bailey said that ‘core inflation’ – which excludes food and fuel prices and has “more persistent inflationary dynamics” – was running at 6.2 per cent, below the overall annual rate but still three times the target rate for consumer price index inflation. He also cited the potential impact of tight labour markets and wage growth.

No Divergence Just Yet

Bitcoin and Cryptocurrency stock market exchange candlestick chart
Bitcoin and Cryptocurrency stock market exchange candlestick chart

All this means that while prospects for multiple further rate increases at the ECB are diminishing, it looks highly likely that the UK base rate has some way to go. For example, This is Money reported that experts are predicting the base rate to go on increasing to the point that it climbs to 5.5 per cent by the end of the year, the highest rate since 2007.

At the same time, it also noted that Investec economist Philip Shaw had said another ECB rate rise at its June meeting is “virtually certain”, raising the Eurozone rate to 3.5 per cent. That suggests any carry trade involving the Euro and Sterling may not be quite so advantageous in the coming months.

The key question, therefore, is whether a recession brings a significant change to longer-term Eurozone monetary policy. Will the ECB, as would seem logical, stop raising rates sooner than the Bank of England? Moreover, will it start to cut them sooner?

It is in these details that the wisdom or otherwise of a carry trade involving Sterling and the Euro is to be found. But these are just two currencies among many around the world that will be on different trajectories as the food and fuel shocks to inflation dissipate and the different ‘core inflation’ factors become increasingly important.

Why The Yen Will Stay Put

Of course, the standard approach might still simply be to start with the Yen. The current Japanese situation is an interesting one, to say the least; After dipping to a six-month low of 3.2 per cent in March, the country’s inflation rate was up again to 3.5 per cent in April. This is, however, still below the January peak of 4.3 per cent, itself a 41-year high.

Inflation may be high by Japanese standards, but even the January figure was less than half the rate prime minister Rishi Sunak pledged to ‘halve inflation to’ (a slightly disingenuous promise given the interest rate the Bank of England has had since 1997). That fact, combined with economic growth running at 2.7 per cent, the Bank of Japan may feel its loose economic policy is justified.

As a result, the 0.1 per cent base rate may stay in place in Tokyo for the foreseeable future, which in turn could make both Sterling and the Euro among the currencies that will be increasingly beneficial to use in combination with it for carry trades.

On Top Down Under?

The Investopedia definition of a carry trade mentioned the Australian and New Zealand dollars as examples of currencies often paired with the Yen this way. They, like many non-European currencies, may be impacted by different inflationary trajectories after recent global events.

Due to their swift lockdowns and strict immigration rules, both were hit less hard by Covid than most, but opened up to global travel later (making their currencies more valuable thanks to pent-up travel demand). At the same time, these are countries far less affected by the geopolitical impact of war in Ukraine, with no dependence on Russian oil and gas or Ukrainian wheat.

However, global market prices still have an impact. For instance, in the first quarter of this year, Consumer Price Index inflation in Australia was seven per cent, with a major contributor being a 14.3 per cent rise in energy costs. All this prompted the Reserve Bank of Australia’s board to raise rates again at its May meeting, despite some signs, like in the UK, that inflation had peaked.

Conclusions

Investor trading crypto currencies online work at home. chart suitable for Stock market forex

In summary, except for Japan, inflation has increased to an alarming extent across different economies and the nature of the monetary response, alongside the published rationale for doing so, has been similar. 

All of that means the Yen remains a prime currency to pair a counterpart with for a carry trade right now, but the possibility of significant economic divergence as particular global factors drop out of the inflation equation and more regional and even national elements become increasingly influential could add to overall differences in wider economic performance and monetary policy responses.

In short, the difference between Sterling and the Eurozone is definitely one to watch. Both may be currently subject to central banks keen to tighten the screws, but the variance of economic fortunes means that a fork in the road may not be far away.

Should you be looking for funding for your carry trade plans, it will be important to show that you have taken these kinds of factors into account.

The Yen may offer an easy win, but for that reason, everyone will be doing it. To add to this a well-planned strategy of taking advantage of emerging differentials in interest rates elsewhere will give you another angle and further means of making successful trades.

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