Who is afraid of the big bad carry trade?
Quite often, I am asked what my biggest regret is from an investor’s perspective. My regret dates back to the pre-financial crisis months of 2007. No, I can reassure you right away: the regret is not that I was invested in the US real estate market or in some fancy credit structure. It is related to the currency market and that I didn’t take some mispricing there more seriously, both as a risk signal and as a possible investment opportunity. If I had, I could have benefited from one of the very few hedges as chaos broke loose in September 2008.
Looking at currency valuations back in 2007, my colleagues and I discovered tremendous “gaps” among the G10 currencies; some exchange rates were very far away from their fair values as estimated by one of our purchasing power parity models. Between January 2007 and August 2008, we observed six months when the Australian dollar (AUD) was overvalued by more than 60% against the Japanese yen (JPY). This valuation gap was extreme, and has only been seen in fewer than 3 % of all observations since January 1982.
Digging deeper, we discovered that this overvaluation was closely related to “carry trades.” This is a strategy in foreign exchange markets that consists of borrowing funds in a low-yielding currency (the sell side of the transaction) and investing this amount in a high-yielding currency (the purchase side of the transaction). The yield difference between the two currencies represents a gain if the exchange rate does not move to such an extent that it erases the interest rate differential. For example, taking on short-term (three-month) debt in JPY would have cost 0.9% annualized per year in December 2007. Investing this money in the AUD would have earned a return of 7.3% a year based on three-month money market rates. Hence, this would have yielded an annualized gain of 6.4%, or the difference between the rate paid to borrow an amount and the rate earned on the invested amount.
But this is not the full story of carry trades. If this strategy is adopted broadly, then the price of the JPY will decline and the price of the AUD will go up. In other words, the AUD will appreciate against the JPY, leading to a further gain. This sounds like a money-spinner, but as we all (should) know, there is no such thing as a free lunch, or a perpetual profit-maker. As mentioned, the popularity of this carry trade strategy created a tremendous valuation gap, which resulted in the pay-back during the peak of the financial crisis. Between end-July 2008 and end-October 2008, the AUD lost more than 45% of its value against the JPY. Being invested anti-carry (meaning long JPY and short AUD) back in 2008 would have been an almost perfect hedge to the unfolding financial crisis.
We can again spot tremendous valuation gaps in today’s currency market. Since September 2013, the New Zealand dollar (NZD) has been overvalued by more than 65% against the JPY (the AUD is “only” overvalued by 55%). Does it mean that carry trades are back in full force and herald some crisis yet to come? Unfortunately, analyzing financial markets isn’t simple. Back in 2007, Japan was a country in deflation. Japanese inflation expectations were nil to negative. Hence, one could expect the purchasing power of the JPY to stay where it was or even to increase against other currencies. Therefore, the JPY, chasing its purchasing power, could be expected to appreciate at some stage (this is indeed what happened).
Today, thanks to Abenomics, Japanese inflation expectations are moving higher. This means that market participants expect the purchasing power of the JPY to decline. Therefore, this time around it is not the currency chasing its fair value but the fair value chasing the currency that could be the driving force of a return to equilibrium. Given the tremendous undervaluation of the Japanese yen, the implied expected inflation is therefore huge. In my view, this is where we should look for the cracks.