The Biggest Carry Trades

The Bank of Japan's plan to double the country's money supply over the next two years has put the spotlight back on the global carry trade.

Japan's lost decade served as the breeding ground for the development of "the mother of all carry trades" in the yen.

These trades are seen as "no-brainers": borrow money in a currency where interest rates are low and invest the money in a currency or a country where interest rates are higher.

But when these currency flows unwind they can create some spectacular blow-ups and investment losses, such as the collapse of the U.S. hedge fund Long-Term Capital Management.

We've identified some of the biggest carry trades based on either the interest rate differential or their popularity.

Click ahead to find out which currencies are popular as well as for some historical perspective on these trades.

By Maria Sovago
Posted May 22 2013

The Aussie is known as the "King of the Carry".

With major central banks offering such low interest rates, it's not just the classic Aussie-yen – but also the and Aussie-euro currency pairs – that are viewed as attractive. The Reserve Bank of Australia (RBA) cut the base rate to a record-low of 2.75% this month, but the country still has the highest interest rates of any triple-A rated country.

Yield-seeking inflows have inflated the Australian dollar, and analysts are starting to warn the currency is due for a major correction.

Rumors that George Soros might be behind a $1 billion bet placed against the Aussie right before the RBA monetary policy meeting hit the currency and fueled expectations that the tide is turning.

Australia's commodity-heavy economy is also dependent on its biggest export market, China, meaning that a slowdown in the Chinese economy could further pressure the Aussie.

Mexico, with close ties to the resurgent U.S. economy, is seen as safer target. Investors are buying the Mexican peso with funds borrowed in the U.S. or in Japan.

But a dramatic example of the reversal in the peso carry trade came in 1994 and became known as the "Tequila Crisis". Struggling with a high current-account deficit and hyperinflation, Mexico pegged the peso to the U.S. dollar in 1988 – but when the U.S. raised interest rates, the Mexican currency could not keep the peg and a surge in capital outflows led to a crash.

Turkey has been sucking up foreign capital of late, as many have been putting the U.S. dollar to work in Turkish bonds or equities.

But analysts have warned the Turkish bull market is increasingly too popular. Stock investors are looking to squeeze the last drops of juice out of the country.

The Turkish central bank has eroded the lira carry by cutting rates to counter the adverse consequences of large capital inflows on financial stability and the currency.

Moody's recently upgraded Turkey to investment grade, the first time since 1994. The decision sent bond yields to record lows.

Emerging market local currency bonds have benefited from loose global monetary conditions. Throughout 2012, many investors played the carry trade on smaller, less-liquid markets, like the Hungarian forint or the Polish zloty.

Both countries are European Union (EU) members, but are outside the euro zone. Investors betting on these currencies use the euro and dollar as the main funding currencies.

However, the exchange rates in these countries gyrate more violently in times of market stress. The Hungarian forint has been on a roller-coaster ride over the past year.

The bond markets of these countries also are much smaller, so it can be more difficult to sell quickly if needed. The possibility of further rate cuts and "unorthodox" policy measures add another element of risk.

Even African markets are attracting capital in the chase for high returns. South Africa, the continent's largest economy, is particularly popular and considered distinct from the frontier markets of other countries.

But there are also plenty of risks. The rand has weakened significantly against the dollar recently as a result of inflation fears and worries about the fragility of the economy. A series of violent labor strikes in the mining industry have hit mining stocks as well as business confidence.

There are also worries about another sovereign downgrade for the country. Some of the more frontier markets of Africa can be especially risky because analysts warn of a "tiny hole to get out of" when everyone wants to sell. The risk is the classic credit illiquidity. Especially when the Fed exits its quantitative easing (QE) program and investors try to sell their bonds.

If history is to be repeated, Indonesia and Thailand are among the preferred markets for Japanese investors looking to enhance returns abroad, although questions are being raised about what the policy response of Asian governments will be to address competitiveness relative to the weaker yen.

In the mid-90s, carry traders borrowed in yen - where the interest rates were just above zero – and invested in anything with the word "dollar" in it. They put their money not just in U.S. and Australian dollars, but also in Southeast Asian countries, where the national currencies were pegged to the dollar.

The unwinding of these flows was a key factor in the Asian financial crisis of 1997, when the so-called Asian Tigers' local currencies plummeted. Thailand's baht, Malaysia's ringgit, South Korea's won and Indonesia's rupiah all underwent dramatic devaluations against the dollar.

As a commodity-rich country, the Russian ruble has been a popular carry trade with a rich yield.

The country's central bank recently left its benchmark interest rate unchanged. But the new central bank governor is expected to switch to a pro-growth bias and cut interest rates, reducing the ruble's appeal.

The carry trade in the ruble has also delivered one of the most famous blow-ups in history. U.S. hedge fund Long-Term Capital Management was forced to liquidate its highly leveraged carry trade positions in August 1998, when Russia defaulted on its sovereign debts, and hot money fled from emerging markets back to the safety of U.S. Treasurys.

The bond investments were financed with borrowings, but as the spread between U.S. and emerging market bonds widened, the hedge fund was forced to provide more collateral.

10-Year Bond Yields: Italy 3.88%, Spain 4.18%, Greece 8.125%

Betting on the euro zone peripheral bond markets may not seem like a traditional carry trade because the funding currency can sometimes be the same, but it's been a hugely popular trade in recent years.

Many investors suffered impairments on their Greek bonds during the bailout of that country.

But for investors in Irish, Portuguese, Spanish or Italian sovereign bonds (GIPSIs) there have also been rich returns after the European Central Bank vowed to do everything possible to save the euro in late 2012.

This year, Japanese bond investors have bid up peripheral bonds as they've used ample liquidity in their country to buy higher-yielding bonds in Italy and Spain.

There's growing risk as well as bond markets seem to have decoupled from economic fundamentals. Spreads between Italian and Spanish bonds and those of Europe's powerhouse Germany have been tightening in spite of weak economic data.