The U.S. dollar has, somewhat erratically, been getting stronger this year.
A currency’s strength is of course based on its popularity — supply and demand work for currencies just like they do apples or stocks.
The popularity contest for currencies sloshes an estimated trillions of dollars around the world each year not just from trade, but investment as well. Money goes where money grows, and investors park their money accordingly.
One factor in a currency’s popularity is the interest rates provided by its home country. Interest rates differ widely around the world as different countries with different economies face different problems.
“Japan has had zero rates really since the 90’s,” said Win Thin, global head of market strategy at Brown Brothers Harriman.
“They have hiked recently,” he said “but they remain incredibly low compared to the rest of the world.”
U.S. rates, in contrast, are over 5%, Mexico’s are over 11% and Turkey’s are over 45%. A certain type of investor looks at all that and sees a way to make money through something called the “currency carry trade.”
It’s a particular type of bet that investors make when they think they can earn more money in one country than in another.
“It boils down to borrowing in a low interest rate currency and putting that into a high interest rate currency,” said Thin.
Borrow some Japanese yen, where you pay a super low interest rate on your loan. Invest that somewhere else on the planet, where you earn a high interest rate. You keep the difference. That is the essence of the currency carry trade.
Paresh Upadhyaya is director of fixed income and currency strategy at Amundi US and explains how it’s done. He opens up a spreadsheet full of economic data on different countries and regions and looks at where interest rates are high.
“We like the Kazakh Tenge, the Uzbek Suma,” Upadhyaya explained, “are all very high yielding, some of them are super high yielding.”
Some investments in Turkey are offering 51% interest. But, there’s of course, a catch.
“You don’t jump into a country just because their interest rates are high. Those interest rates are high for a reason,” he said.
That reason could be a country is fighting a lot of inflation, or it could be that the whole country — its politics, and its economy — are unstable and you don’t trust you’re going to get your money back.
And there’s another, bigger catch.
“You can have very high yields,” Upadhyaya cautions, “but those yields could be more than wiped out by the volatility in the country’s exchange rate.”
It’s all fine and good if you borrow yen and make a million Australian dollars. But if one day the exchange rate changes, and those Aussie dollars are suddenly not worth the yen you owe back over in Japan, you are in very big trouble. This exact thing actually happened during the 2008 financial crisis.
“People lost so much, so much money,” said Upadhyaya.
As concern over the financial system mounted, and investors moved their money to Japan as a safe haven, the yen increased in value while the Australian dollar started to lose value. Investors ran for the exits, pulling as much of their money out of Australia as fast as they possibly could, “violently selling their Australian dollars” and trading them back into yen to pay off their yen loans.
That only made things worse by making the Australian dollar even weaker and the yen even stronger.
“This is how much it moved: 46.7%. Massive. Just massive,” said Upadhyaya as he pulled up a chart.
This is how the carry trade and investors trying to execute it can cause entire nations’ currencies to make big moves, sometimes very quickly.
“That can actually destabilize the whole exchange rate market,” said Markus Brunnermeier, professor of economics and director of the Bendheim Center for Finance at Princeton.
Sudden moves in currency can cost exporters money or create inflation for consumers.
At the same time, many countries depend on this money to flow into or out of them, but preferably slowly.
“Overall some form of carry trade is also healthy,” said Brunnermeier.
It can help a struggling economy grow, he says. It can also help an overheating economy cool down.
“It’s an important disciplining mechanism,” said Eswar Prasad, professor of trade policy at Cornell.
Interest rates of major currencies around the world are expected to begin moving further out of lockstep, as their battles with inflation are winding down at different rates. That would mean opportunities for more carry trades are opening up. That, in turn, could lead to more currency volatility in the year ahead, said Brunnermeier.
“This is a critical time for the currency carry trade,” said Win Thin at Brown Brothers Harriman.
The trade is just one of many ways investors chase returns around the world. But it illustrates something fundamental: different countries’ interest rates are like magnets pulling money around the world, and moving currencies with it. That is the less talked about power of interest rates.
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