The difference between the two interest rates creates potential profit for investors. It is of particular note in the credit crisis as US interest rates have been very low – sparking a rise in the deals. The dollar carry trade can have an impact on exchange rates and can push up the cost of commonly used commodities, such as oil and steel.
Cash and carry: how the numbers stack up
In carry trades, money can be borrowed at the low interest rate then invested as a bank deposit or some other instrument in another country that has a higher interest rate. For example, depositing money for one month in an account in Australia earns about 3.9% a year at the moment, compared with the borrowing cost in the US of about 0.2% a year. The difference between the interest rates leads to a potential profit for the investor. But be warned, while it may sound simple, currency investing is very risky and currencies can move quickly in unexpected ways.
Three ways dollar carry trades can go wrong
Dollar carry trades are complex – with monetary policy and wider exchange rate movements able to wipe out profits and cause a loss. The first of three big challenges for making dollar carry trades work is rises in the rate at which money is borrowed. Such a movement could happen if the US central bank, the Federal Reserve, raised interest rates. The second big challenge relates to the central bank in the country where the money is deposited. If that central bank lowers rates, the rate of return could in turn fall as well. The third involves regular movements in exchange rates. If the currency in which the money is deposited weakens against the US dollar, the return will ultimately be turned into fewer dollars.
Hello Mrs Watanabe: the first generation carry trade was in yen
In the late 1990s and early 2000s, many investors borrowed Japanese yen because interest rates in that country were close to zero. Investors used this money to buy assets in other currencies. This was known as the “yen carry trade”. Yen carry trades are still popular but changes in financial markets associated with the global financial crisis may have reduced their importance.
The global financial crisis has caused rapid movements in exchange rates, falls in global interest rates and uncertainty about the outlook for the global economy.
Dangers with dollar carry trade
Commentators – including well-known economist Nouriel Roubini – argue that if dollar carry trades are reversed quickly, commodity prices could fall rapidly.
It is argued that carry trades can also inhibit countries’ ability to influence developments in their economies through interest rates, as hiking rates could attract foreign money and drive up the exchange rate. A prominent economic adviser to the German government, Peter Bofinger, said in an interview with Spiegel Online foreign exchange markets needed reform.