Bond Spreads and Forex Markets​ (part three) ​

Interest rates are very often a good proxy to predict currencies’ trends and undertake profitable carry trade strategies. Nevertheless, there are also several reasons in which carry trade strategies may fail. ​

First, a trader should remember that the relationship between interest rates and currencies is a long-term one. The depreciation of currencies often occurs several week after interest rate differentials have decreased. As a consequence, carry trade strategies should be undertaken only by those traders who have a time horizon between 6 and 12 months, as markets are imperfect and currency prices reflect the true economic fundamentals between countries only in the short run.​

Second, carry trade strategies are not suitable to traders using too much leverage. Since interest rate differentials are rather small, high-leverage traders are often willing to magnify them. For example, if a trader used 10 times leverage on a 1-per cent yield spread, he would turn 1.0% into 10.0%. Many forex brokers offer up to 100 times leverage, tempting traders to take a higher risk. However, too much leverage can prematurely push a trader out of the market in the long-term because he will not be able to tackle short-term fluctuations in the market.​

Third, the success of yield-seeking forex traders is often related to the lack of attractive stock market returns. In 2004 the yen soared despite the Bank of Japan’s ZIRP policy, since the Japanese stock market rally granted higher returns to underweighted investors. Many who had cut off exposure to Japan over the previous decade because of the country’s economic stagnation and deflation, poured money back. Stock markets play an important role and may reduce the success of bond yields forecasting currency movements.​

Finally, traders should consider the importance of risk. Forex trades based on yields are historically most successful in a risk-seeking environment than in a risk-averse one. In risk-seeking environments, investors reshuffle their portfolios and sell low-risk/high-value assets and buy higher-risk/low-value assets. Riskier currencies offer a higher return to compensate investors for a higher risk of a currency depreciation than the one predicted by uncovered interest rate parity. The higher yield is an investor’s payment for taking this risk. However, in times when investors are more risk averse, the riskier currencies – on which carry trades rely for their returns – depreciate. These currencies are related to countries which usually have high current account deficits and, as the appetite for risk reduces, investors turn to safe domestic markets, making these deficits harder to fund. This is why it makes sense to unwind carry trades in rising risk aversion environments, since adverse currency moves tend to at least partly offset the interest rate advantage.​

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