Carry Trade
(the basis for this page is the inflation and interest rates page)
If a country sees high inflation and/or high wage increases (historically the main driver of inflation) thanks to an improving economy, then the central bank is obliged to raise the key interest rates. If the country has a good rating, then the currency typically appreciates.
The logic is identical to that behind any investment. The investor seeks the highest returns possible provided that the investment seems to be sufficiently secure. Countries that offer the highest return on investment through high interest rates, economic growth and growth in domestic financial markets tend to attract the most foreign capital.
As you can see, it is not just the rate itself that is important. The direction of the interest rate can act as a good proxy for demand for the currency. The direction of the interest rate is obtained through the central bank’s language in the statement that accompanied their target rate decision. The accompanying statement is analyzed word-for-word for any signs of what the central bank may do at the next meeting. The interest rate decision itself tends to be less important than the expectations for future interest rate moves.
High and increasing rates at the beginning of an economic expansion can generate growth and value in a currency. On the other hand, low and lowering rates may represent a country experiencing difficult economic conditions, which is reflected in a reduction of the currency’s value.
The Widening Interest Rate Differential
In early 2009, the worldwide economy was bottoming out as the United States’ credit freeze began to thaw. The Fed kept U.S. interest rates at all-time lows while the Reserve Bank of Australia began their process of increasing their target benchmark rate.
Since this was at the beginning of an economic expansion, foreign investors into Australian companies needed Australian Dollars to make their investment. Additionally, FX traders began buying the AUDUSD currency pair in anticipation of this demand for the Australian Dollar.
Those traders were rewarded as the AUDUSD exchange rate began a 30 cent rise while earning an additional daily dividend from 2009 through 2011. One mini lot trade of 10,000 units of currency would have yielded over $3,000 plus interest.
Central banks hike interest rates not only to stop a depreciation of the currency.
The Carry Trade Era between 2003 and 2007: undervalued franc
During the carry trade period between 2003 and 2007, the euro strongly increased against the Swiss franc, but from 2004 to 2007 the Swiss GDP growth was on average 0.5% stronger than the one in the Eurozone.
The EU-Swiss bilateral agreements helped to increase the number of foreign workers by 23% between 2005 and 2011, whereas the number rose only by 10% between 1992 and 2005. As opposed to former migrations into Switzerland this time foreign employees are mostly highly qualified. Since German wages were relatively low (see previously) German personnel like engineers and computer scientists found it attractive to work in Switzerland and were quickly integrated thanks to the common language. The increasing migration caused rents to go up by more than 2% per year between 2006 and 2009 even during the global financial crisis. Wages increased similarly.
Swiss inflation was low and considerably lower than in the euro zone. The reasons were:
- Lower inflation in all industrialized countries than previously thanks to an aging population and cheap imports from developing nations like China
- Slow growth and slow wage increase in both Germany and Switzerland between 1997 and 2004 (see 3.1.)
- Moderate increases in Swiss housing prices compared to most other countries thanks to more rigid bank requirements after the bad experience of the Swiss housing bust in the 1990s.
- Lower dependency of Swiss companies on the rising oil prices thanks to increased use of water and atomic energy and resulting lower commodity price inflation than the one of the euro zone.
- Further opening of the Swiss market to foreign companies and imported products reduced prices (examples: German low-cost retailers Aldi and Lidl came to Switzerland)
The global carry trade favored high-yielding currencies against low yielders like the yen and the franc. The Swiss CPI was consistently under the SNB price stability target of 2%. Therefore the SNB did see any need to raise interest rates till inflation had become a bit stronger in 2006 and the ECB first started to hike rates. Even if the US housing market started to tumble in 2007, Swiss real estate continued its rise.
The SNB ignored the stronger growth in Switzerland than in the Euro zone : The SNB rates remained steadily between 0.75% and 1.25% under the ECB rates . This gap together with a high risk appetite caused an undervaluation of the Swissie between 2004 and 2010 in terms of the real effective exchange rate and purchasing power parity.
Real exchange rate: export-weighted vs. GDP-weighted (see more)
The Reverse Carry Trade
Another Forex rule states that a state with a current account deficit needs to re-compensate this lack of safety via higher interest rates. Low debt, a positive current account and a positive net international investment position (NIIP), the country typically obtains a good credit rating. All these factors help to reassure investors that their money is safe.
If a states experiences the opposite, high debt and a weakening current account balance, this drives money out of the country and weakens the currency. It causes inflation to rise. The central bank then often hikes interest rates that attracts capital again and slows inflationary effects.
Till the 1990s the Bank of Italy followed this principle and was regularly constrained to hike rates against the Lira’s depreciation with the effect that Italy had to pay higher interest on its bonds. This drove Italian public debt/GDP to over 100%, but kept the country competitive.
The appreciation of the Swiss franc since the financial crisis, this is the manifestation of the reverse carry trade.
In summer 2011, the rate differential between the euro zone and Switzerland arrived at 1.5%, but despite this widening interest rate differential, the EUR/CHF continued to depreciate to parity. The reason was the high importance of risk averseness in the form of the reverse or inverse carry trade. More details about debt and risk averseness is here.
Inflation, Reverse Carry Trade and the Influence on the EUR/CHF Exchange Rate
The SNB cap on the franc does the same as the Bank of Italy did: it protects the Swiss current account surplus. We will see that similarly to what the Bank of Italy did, this cap on the franc can only end in higher public debt, in this case via SNB losses.
Therefore, we think that the euro zone will need to offer at least 1.5% to 2% higher interest rates than Switzerland so that the SNB is able to sell (a big part of) their currency reserves.
Peripheral wages must fall in comparison to German or Swiss salaries in order to make the periphery competitive again. For this reason inflation pressures and interest rates in the euro zone will be subdued.
Swiss wages are expected to remain stable this year. However, 58% of Swiss imports come from Germany, but German wages are currently rising by 3% YoY. Therefore the Swiss prices will go up in 2013, if the floor is maintained. Credit Suisse expects Swiss inflation to rise to 1% in 2013. If the SNB insists on the floor, then she will lose control of monetary policy.
Similarly, as previously in Greece or Ireland, Spanish or Italian inflation might fall to levels between 1% and 2%. Spanish companies did not reduce salaries, but due to inflexible labor laws, they fired especially younger personnel.
Even if inflation pressures in Germany, Finland and Austria exist, we do not think that the ECB will opt for big interest rate hikes in the next 3-5 years. The main chance to sell reserves for the SNB would be a return to the carry trade period, but given the persisting risk differentials this is extremely unlikely.
Must a carry trade always end in a currency crash?
The following paper from the NBER claims that a carry trade often ends in a currency crash.
