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Sunday, June 9, 2013

Carry Trade Backfires!

Speculators love carry trades.  When done right, risk is minimized and can seem non-existent.  Speculators are helped along when central bankers are transparent.

To do a carry trade, you want to borrow at a low rate and invest the proceeds at a higher rate.  Leverage the trade, and you can make some big bucks - as long as it works as expected.

The premier carry trade for decades has been to borrow in Japan at low rates and invest at higher yields elsewhere.  Today that elsewhere has been Europe.  Given that Abenomics has committed to raising Japan's inflation rate by keeping rates low, it means the trade will hopefully be paid off in cheaper Yen.

But as Keynes once said, "there is many a slip twitx the cup and the lip."  Last week, ECB president Draghi indicated that easing moves were not imminent (if yields rise, the trade loses as bond prices drop!); and holders of Spanish and Italian bonds sold, driving their rates higher.  As they sold, they reversed the carry trade by paying back the borrowing in Japan, causing the Yen to appreciate in value and thus the "slip" Keynes talked about.  The fallout included a sharp decline in U.S. stocks, and the tsunami moved down the liquidity chain until the Yen stabilized.

And so...another source of volatility in a volatile market.

1 comment:

  1. "Speculators love carry trades." Thankfully I prefer investing rather than speculating! But as you say, there are big bucks to be made ... if it works out!