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The Carry Trade: What Is It And How To Play It?
By Everyday Finance on November 5, 2009 | More Posts By Everyday Finance | Author's Website
There’s been a lot of press lately about the Carry Trade, and like all catchy trends in the investing world, by the time it’s a routine fixture on CNBC and blogs, the smart money’s been made and retail investors are left holding the bag when the bubble bursts (anyone recall housing 2007, oil 2008?). Conversely, the trend is your friend and given the continued decline of the US dollar of late, we may very well see this trend continue for months. In a flat or downward stock market following a 60% move from the bottom, the carry trade may be a nice place to earn a double digit gain in the meantime.
As outlined in this article on Currency ETFs, there are some currencies that are making great gains against the US Dollar and investors could have captured some nice low-correlation gains alongside stock gains in the past few months and this may continue.
What is the Carry Trade Exactly?
Essentially, because the US has a near 0% interest rate and other economies have higher interest rates or are even raising them due to the relative strength and confidence in their economies (like Australia), currency ETFs such as FXA (FXA) (Aussie Dollar) are on fire. This year, you would have even done better in FXA than the S&P 500 (^GSPC), even given the recent rally.
Chart 1: YTD Return FXA +28% vs. S&P500 +15%
With all the talk of the US Dollar being displaces as the reserve currency of choice, we’ve seen gold rally to all-time highs, which is very much a function of the weakening dollar (see why silver-platinum ETFs are even better investments than gold in a weak dollar environment) as opposed to a supply shortage or industrial demand. Meanwhile silver and platinum benefit from actual real-world industrial utilization and are more leveraged to a weakening dollar even than gold.
However, aside from a commodities trade or trying to pit Australia alone vs. the US, another ETF that goes long the highest yielding currencies and short the lowest yielding currencies is DBV - PowerShares DB G10 Currency Harvest. This one is considered a broader play on the carry trade rather than betting on the relative strength of individual currencies.
Carry Trade Bubble Risk
To be clear, playing the carry trade this far into the dance is not without risk. Prominent B-School professor and oft-doomsayer Roubini has been warning of the imminent collapse of the mother of all carry trades. The video’s a bit long, so I’ll summarize. He warns that when the carry trade reverses (the bubble bursts) and investors have to cover their short dollar positions, panic will ensue and investors will rush for the exits. In doing so, the dollar will rally to the tune of 25% or more and overseas currencies will crash precipitously. Those that are long foreign currencies and short the US dollar will get crushed. Indirectly, all risky assets will suffer including stocks and bonds like we saw in 2008 into 2009.
This would be akin to what we saw during the global collapse and complete capitulation of the investment world at large in March 2009 where even the weak dollar-gold correlation broke down for the first time in years - and then promptly recovered as we’re seeing now. Therefore, if you’re a contrarian and want to wait it out for this bubble to burst, you’d want to stay out of commodities, stay out of the foreign currency ETFs and just go long the dollar or Treasuries.
Disclosure: No positions in currency ETFs. Engaged in hedged Treasuries ETF strategy that is net neutral.
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Am I dumb or what?/your article says “The carry trade-What is it And how to play it”
You do not explain or give examples. In fact you missed the whole point of your article.
I’m still in the dark.
Walter
Sorry if it wasn’t clear; this statement had some context, but it wasn’t spelled out explicitly:
“Those that are long foreign currencies and short the US dollar will get crushed.”
Basically, right now, investors are shorting currencies with low interest rates (like the US Dollar) and long currencies with high interest rates (like Australia). It’s like getting the float (difference between interest rates) for free, before factoring in currency fluctuations of course - of which, the dollar has only continued to decline of late. So…the carry trade has been very profitable recently, but if it reverses, it could be quite painful.