Traders' practice of borrowing low-rate currencies, such as the yen, to invest in higher-yielding ones has been blamed in the past for fuelling asset bubbles. These so-called carry trades probably would be welcomed right now by those central bankers who want weaker currencies. Monetary policymakers are out of luck.
Carry trades only thrive in certain conditions. Interest rate differentials between funding and target currencies need to be wide enough and likely to persist. Traders also need to be fairly confident that the funding currency won't suddenly appreciate and wipe out profits. Such bets therefore tend to work best when financial markets are in risk-seeking mode and less prone to huge gyrations.
The first condition is definitely in place. European Central Bank President Mario Draghi has slashed policy rates to record lows and hinted on January 21 that more easing was on the way. Bank of Japan Governor Haruhiko Kuroda lowered a benchmark interest rate to below zero on January 29. Both insist that there are no limits to the monetary easing they are willing to contemplate to revive inflation.
However, the second prerequisite for carry trades to be lucrative is missing. Traders are unsure about how currencies, let alone global financial markets, will behave, leaving them wary of placing such bets. Risk aversion is causing waves of money to flow into euros and yen and strengthening these currencies. The possibility that central bankers lack the weapons to combat a slowdown in the global economy compounds the unhelpful volatility in currency markets.
Carry trades can become loss-making propositions when funding currencies jump around a lot, and especially when they appreciate. The single currency has gained 3.6 per cent against the dollar since Draghi suggested more easing, while the yen has appreciated 5.5 per cent against the greenback since the Japanese rate cut. Neither cuts the mustard as a funding currency right now. Draghi and Kuroda might wish they would.
