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Rethinking Carry in a New World

Rethinking Carry in a New World

  • The carry trade, a popular strategy for generating steady returns, is facing unprecedented challenges.
  • The era of "easy carry" may be ending, as rising interest rates and geopolitical shifts disrupt traditional strategies.
  • How should investors adapt to the new carry trade landscape and manage the evolving risks.

The sharp unwinding of the Japanese Yen carry trade in August 2024 served as a stark reminder of the inherent risks of carry trades. Much like the sudden market crash triggered by the COVID-19 pandemic in 2020, the Yen's volatility revealed the precarious foundation upon which carry trades are built.

But are these recent tremors merely isolated incidents, or are they harbingers of a more profound shift in the global financial order — an end to the "Carry Trade Regime?"

"Taking a step back, carry is a trade that makes money if nothing happens," explains Kevin Coldiron, co-author of The Rise of Carry. At its core, a carry trade involves borrowing in a low-interest-rate currency and investing that borrowed money into an asset with a higher yield.

Investors often use leverage to magnify these potential returns, making the strategy particularly attractive in periods of market calm. Think of it as a bet on stability and predictability. But as Kevin emphasizes, the inherent risk lies in that "something" happening to disrupt this carefully balanced equation.

Familiar examples of carry trades include the classic Yen carry trade, where investors borrow in Japanese Yen at ultra-low rates and invest in higher-yielding assets in other countries. However, the carry trade phenomenon extends beyond currencies. "Financial markets really behave as a kind of giant carry trade," Kevin points out, noting that even broad market indices, like the S&P 500, exhibit characteristics of this leveraged, stability-dependent strategy.

Read on to gain a deeper understanding of the carry trade's past, present, and uncertain future.

The rise and evolution of carry

Kevin began by painting a picture of the carry trade's evolution over the past few decades. He described a period he calls the "Carry Regime," characterized by the remarkable growth and expansion of these strategies across all corners of the financial markets.

“Carry trades over the last 30 to 40 years have grown from being niche strategies mainly applied in the currency market and commodity markets to strategies we see everywhere,” Kevin explained.

What was once a specialized tactic employed by a select group of traders has become a pervasive force shaping global market behavior. This rise of carry, Kevin argues, has profoundly impacted the financial system, contributing to a surge in leverage and interconnectedness.

“They’ve grown in size and scale to the point where financial markets, the global market, really behave as a kind of — if not a giant carry trade, they have the characteristics of a carry trade,” he observed.

This widespread adoption of carry-like strategies, with their inherent reliance on leverage and stable market conditions, has created a system that is both remarkably efficient in generating returns during calm periods and highly vulnerable to sudden shifts in sentiment or unexpected economic shocks.

Kevin highlighted the inherent fragility of this system, pointing to the COVID-19 crash of 2020 as a prime example of how rapidly leveraged carry trades can unravel when confronted with unexpected volatility. “The [COVID] crash, some might say, has got nothing to do with carry. That was a global pandemic," Kevin acknowledges. "In this case, the trigger was ‘fundamental’, right? There was a fundamental reason for markets to fall, but once they started falling, these levered carry trades started losing money."

He suggests that the sheer scale of carry trades today means that any disruption, whether fundamental or technical, could trigger a cascade of unwinding, leading to significant market volatility and potential losses.

The cracks in the carry regime

While carry trades have flourished for decades, Kevin and Alan identified several significant challenges and potential disruptions to this seemingly well-established model.

One of the most prominent shifts has been the changing role of the U.S. dollar. As U.S. interest rates have risen, the dollar has transitioned from being primarily a funding currency for carry trades to more of a recipient currency. This shift has significant implications for carry trade dynamics, ” because this has led to increased reliance on less liquid funding currencies like the Japanese Yen, potentially making carry trades more susceptible to volatility and sudden unwinding.

Adding to the complexity is the challenge of managing carry trade risks in an environment of rising inflation. Central banks, tasked with maintaining financial stability, face a dilemma when market disruptions occur. "In a world where the underlying risk is inflation, then responding with a liquidity injection is a lot riskier," Kevin cautions.

Silicon Valley Bank's collapse in early 2023 illustrates this dilemma, where the Federal Reserve's intervention to stabilize the banking system occurred against a backdrop of already elevated inflation. This action, while successful in containing the immediate crisis, raised concerns about the potential for moral hazard — encouraging excessive risk-taking in the belief that central banks will always step in to provide a safety net.

Beyond interest rates and inflation, geopolitical fragmentation is casting a shadow over the future of carry trades. Events like the Russia-Ukraine war and China's changing approach to global capital flows are disrupting traditional patterns of investment and potentially reducing the availability of funding for carry trades.

“It's impacted that circular flow of dollars. China [and] the big commodity oil exporters are not recycling those reserves back into treasuries,” Kevin observes. This shift in global capital flows, combined with heightened geopolitical uncertainty, is creating a more complex and unpredictable landscape for carry traders.

Kevin suggests that this new reality might lead to a greater prevalence of capital controls or taxes on short-term capital flows as governments seek to mitigate the destabilizing effects of large-scale carry trade unwinds.

Investing in a world of unwinding carry

Given the evolving challenges facing carry trades, what does this mean for investors? Kevin and Alan offered some valuable insights and practical advice for approaching carry trades in this new environment.

First and foremost, they emphasized the importance of recognizing the inherent fragility of carry trades. While these strategies can deliver consistent returns during periods of stability, they are highly sensitive to unexpected events and market volatility.

"It's very hard to lean against carry," Kevin cautions. Investors need to be aware of the potential for sudden and significant drawdowns, especially when leverage is involved. He points out that even seemingly unrelated events can trigger a cascade of unwinding in leveraged carry trades, leading to sharp market corrections.

In this context, a keen focus on risk management is critical. Diversification, prudent position sizing, and avoiding excessive leverage are crucial for mitigating potential losses. “I spent most of the early summer thinking about how I could make money from the Yen carry trade unwind," Kevin admits. "I looked at setting up a bank deposit account where I just moved dollars, but then you’re paying away the carry, right?"

Profiting from carry trade unwinds is challenging even for seasoned investors. Kevin suggests that a more realistic approach might involve setting limit orders at levels below current market prices, essentially waiting for assets to become more attractively priced during an unwind.

Finally, Kevin and Alan stressed the importance of staying informed about global macroeconomic trends, central bank policies, and geopolitical developments that could impact carry trades. The financial landscape is in constant flux, and investors need to be proactive in monitoring these changes to adjust their strategies accordingly.

They highlighted the need to pay close attention to signals like rising real interest rates, which could indicate a shift in the underlying growth potential of the economy and impact the sustainability of carry trades. As Kevin advises, be prepared to "look for vulnerabilities, be willing to step in below the current level and have some cash to be able to do it."

This proactive and adaptable approach, combined with a deep understanding of the risks, is essential for navigating the complexities of carry trades in a world where "nothing happens" less and less often.

The carry trade is at a crossroads

The "Carry Trade Regime," once a reliable engine of returns, is now subject to shifting interest rates, rising inflation, geopolitical fragmentation, and the influence of central banks. Investors who embrace a nuanced understanding of these dynamics, prioritize prudent risk management, and remain vigilant in monitoring global trends will be best positioned to navigate the carry trade's uncertain future.

Brace yourself: The era of "easy carry" may be drawing to a close.


This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.