When Carry Trades Work and When They Don’t

Carry trades work best when investors feel unsafe, but hopeful enough to purchase high yielding currencies and sell lower yielding currencies.

It is a bit like an optimist who sees the glass half full. Although the recent situation might not be ideal, he is positive that things will get better. It is the same with the carry trade, the economic situations may not be that good, however,  the attitude of the buying currency does need to be positive.

If the viewpoint of a country’s economy looks as good as Angelina Jolie, then chances are that the country’s central bank will have to increase the interest percentage in order to control increase.

This is good for carry trade, for the reason that a higher interest rate means a bigger interest percentage difference.

When Do Carry Trades NOT Work?

In addition, if a country’s economic projections are not looking too good, then nobody will be ready to take on the currency, if they feel the central bank will have to decrease interest rates to help their economy.

In short, carry trades work best when investors have low risk aversion.  Carry trades does not work good when risk aversion is high, for example, selling higher-yielding currencies and buying back lower-yielding currencies. When risk aversion is high, investors are less likely to take unsafe ventures.

Let’s put this into viewpoint, let’s say economic situations are threatening, and the country is currently going through a downturn. What would you do with your  money if that happens?

You would probably select a low-paying but safer investment than put it somewhere else. As long the investment is a “sure thing” it does not matter if the return is not to high.

And it does make sense for the reason that this permits you to have a fall back plan in the situation that things are not good.

The mindset of big investors is not that much different from you. When economic conditions are unpredictable, investors are inclined to put their investments in safe haven currencies that offer low interest rates like the Japanese yen  and U.S. dollar.

Read more,  for a specific example, on how risk aversion led to the unwinding of carry trade. This is the polar opposite of carry trade. This inflow of cash in the direction of protected assets causes currencies with low interest to increase in value against those with high interest.

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