With the recent increases in interest rates, the carry trade has had a sudden resurgence in performance, which could make it a tempting strategy for investors. However, we want to caution investors that the carry trade still has embedded risks right now because valuation is against it. Moreover, with the opportunities available in value at the extremes and the potential gains from carry looking quite small, we do not think now is the time to get carried away by the recent performance.
After a bout of strong recent performance brought about by rising interest rates, investors may be tempted to over-allocate to carry. However, we must caution investors that, in this environment, the carry trade is actually riskier than one might think because it requires taking positions against underlying valuations. Historically, carry has worked well when valuation was on its side but has languished when trading against fundamentals. Today, it is the more expensive currencies that are the higher yielding ones, meaning that the current carry trade effectively requires investors to bet against reversion, particularly when currency valuation spreads are at all-time extremes and yield spreads remain quite small.
What is the carry trade?
At its core, any carry trade is simply borrowing money at a low interest rate and depositing it in an asset with a higher yield. In foreign exchange markets, it means borrowing in a currency that has a lower interest rate and investing it in a currency with a higher interest rate. The expectation is that the interest rate differential offers a “carry” or a yield pickup that is greater than any capital loss in the currency you invested in. A successful carry trade depends on multiple factors, particularly the size of the carry (i.e., interest rate differential) and the likely direction of the currency you are investing in. To a lesser extent, but still worth noting, is the volatility of the asset you are investing in. (A large yield pickup in a low volatility asset is preferable to a small yield pickup in a high volatility asset.)1
How has the carry trade performed?
To evaluate the performance of carry as an investment strategy, we look to one of the indices created to track it, the DB G10 Currency Future Harvest Index. This index, which also has an associated ETF (the Invesco DB G10 Currency Harvest Fund; ticker: DBV), represents the performance of a carry strategy using G10 currencies. As per the fund prospectus, the index (fund) takes long positions in the three highest yielding currencies and short positions in the three lowest yielding currencies (with a 2:1 leverage ratio). The historical performance of the index and ETF performance, where available, is shown in Exhibit 1. While the performance of any strategy is dependent on its investment universe and the portfolio construction methods used to implement the strategy, it is worth noting that other carry indices (as well as our own back-testing) show similar performance patterns when using a similar universe.