Carry Trade Returns, With Risks

The carry trade is making a comeback, but in a new form.

The old carry trade was a relatively predictable creature. It meant borrowing funds in low-interest-rate currencies like the Japanese yen, and depositing them into stable high-yield currencies like the Australian dollar — for easy returns.

Critical to the strategy’s success was the notion that currencies like the yen and Australian dollar would trade in relatively foreseeable ways.

Now, investors looking to profit from differences in interest rates have turned to the Indonesian rupiah, the Brazilian real, or even the Russian ruble — far riskier propositions.

Funding currencies like the yen and the dollar are cheaper than ever. Interest rates in both countries are close to zero, with their central banks seemingly intent on printing money to escape recession.

Investors with funds in hand have plenty of options, with rates from 7.5% in Indonesia to 13% in Russia. Fear, meanwhile, is receding: Stocks are up and emerging-market currencies are ticking higher.

Much of the carry trade’s success in its heyday rested on the enormous leverage that investors could deploy to magnify returns. Leverage is now the dirtiest word in the financial lexicon.

While the new carry trade may be less leveraged, it’s a riskier bet. It’s more vulnerable to the swift unraveling of risk appetite observed across all nations and in 2008, but which occurs more frequently in emerging markets.

Investors turning to the Indonesian rupiah have driven the currency nearly 12% higher against the dollar in the past month and been rewarded by an event-free national election that will only bolster investment flows.

It pays to pick your currency carefully.

David Roman