Will the U.S. Dollar Take Over the Carry Trade Crowd?

(eToro Blog) As defined, carry trade is a simple philosophy whereby an investor borrows funs at a low rate of interest then invests them in an asset which offers a better rate of return. Among “traditional” assets, in this day and age of ultra low interest rates for borrowers, you’d be hard-pressed to find a deposit rate that was better, unless you were willing to invest in some higher risk off-shore investment vehicle. But there are other options and hedge fund operators and institutional investors are well aware of them; of course, it’s the currency market and it has become an important strategy among investors of all classes.

In the past, the majority of carry trades were done using the Japanese Yen, which had become for many years a favorite currency to borrow due to low interest rates. With interest rates dropping globally, and indeed with the Federal Reserve’s commitment to ultra low rates for the next several years and their flooding the liquidity markets with cheap dollars, the U.S. Dollar could emerge as the newest carry trade currency.

The theory behind carry trade profitability is that market changes will happen gradually, given a trader enough time to lock in profits or close out a position. While the potential for profit for the U.S. Dollar as a carry trade currency seems substantial (given that nearly every other currency will bear a higher interest rate), there are always risks involved with currency trading and a carry trade strategy is no different.

The pairs which offer the highest opportunity for profits will likely also be the most volatile and as any trader can tell you a market moves fast when investors are nervous and when investors are nervous, risk appetite can be significantly suppressed. Abrupt changes in the market will throw the carry trade strategy off and could result in a trader having to quickly close out their position. That’s bad enough for the individual trader but if institutional traders and hedge funds also feel a change in the wind and close out their carry trades, the wholesale unwinding of those positions could have a devastating affect on the global economy.

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