AROUND $5 trillion is traded on the foreign-exchange markets every single day, according to a recent survey sponsored by the world’s big central banks. That compares with global trade in goods and services of $18.3 trillion a year, or about $50 billion a day.
In other words, the currency markets are not solely devoted to helping German carmakers turn their export earnings back into euros. Even if you exclude deals made between banks, financial institutions account for a much larger chunk of foreign-exchange transactions than other businesses. Shifting capital around the world moves currencies more than shifting goods does.
What inspires investors to favour one currency over another? Perhaps the most consistent factor over the past 20 years has been the “carry trade”. This involves a trader borrowing in a country with low interest rates and investing the proceeds of the loan in a country with higher rates, and pocketing the difference.
In theory, it seems odd that the carry trade works. The most likely reason for one country to have higher nominal interest rates than another is because it has persistently higher inflation. Over time you would expect to see currency depreciation in the high-inflation nation because its exports will gradually become less competitive.
In the forward markets, which set prices for specified future dates, this rule is rigidly observed. When one country has a higher interest rate than another, its currency will trade at a discount to that of the other nation in the forward market. That discount will exactly offset the rate differential. So if euro-zone interest rates were two percentage points higher than those in America, the euro will trade at a 2% discount to the dollar in the 12-month forward market. If it did not do so, traders would be able to make a risk-free profit.
The forward market is a naive “forecast” of future currency movements. But an analysis by Record Currency Management of 33 years of data on five big currencies shows that the currency in the country with the higher interest rate outperforms the forward exchange rate slightly more often than not. This translates into a small monthly gain for investors.
Why is this the case? Neil Record, the founder of the currency-management firm, finds that, with the exception of America (which has the privilege of issuing the world’s reserve currency), countries with persistent current-account deficits tend to have higher real interest rates than surplus countries. In other words, countries with an addiction to imports have to pay a risk premium to investors to hold their currency.
But the carry trade is based on exploiting the difference between nominal, not real, interest rates. Figures from the Royal Bank of Canada (RBC) show a strategy of being long the currency with the highest yields (ie, betting on a price increase) and short the currency with the lowest yields. The most profitable approach over the past 20 years has been to focus on nominal rates (see chart).
One explanation is that nominal rates are a lot easier to target than real ones. Some governments issue inflation-linked bonds, which pay real rates, but these securities are not that liquid. For other bonds the true real rate can only be known in retrospect.
Elsa Lignos, a currency strategist at RBC, calculated the returns investors would have received had they possessed foresight of the rate differentials between currencies. Even on this basis, knowledge of nominal-rate changes was more important than shifts in real rates.
One reason might be that currencies move in line with relative inflation rates (a theory called purchasing power parity, or PPP) only over the very long run. In the short term they can depart a long way from PPP levels. Currency traders are more concerned about the next few weeks than about long-term exchange-rate movements.
If one country has an extremely high inflation rate relative to the rest of the world, its currency will depreciate very rapidly (Zimbabwe is an obvious recent example of the effect of hyperinflation). But the differences between inflation rates across the developed world are very small and so will not have much of an impact on a country’s competitiveness.
Traders who look at differentials between nominal rates know exactly what they are getting and do not have to worry about such complexities as whether different countries are using compatible inflation measures. The carry trade may be simple, but it works.
This article appeared in the Finance & economics section of the print edition under the headline "Carry on trading"