Carry Trade Tumbles After Central Banks Cut Rates

No where in the Forex market would the sudden drop in global interest rates and its subsequent influence on volatility have a greater impact than in the carry trade. Indeed, after the Federal Reserve, Bank of England, European Central Bank and Bank of Canada lowered their benchmark lending rates 50 basis points (the Swiss National Bank cut 25 basis points, while the policy authorities in China and Hong Kong eased half a percent), the yield dependent strategy tumbled. In fact, on the news, the DailyFX Carry Trade Index dropped another 1,200 points to tally the total weekly drop to 12.1 percent and leave the indicator at its lowest level since November of 2003.

The negative impact this event has on the carry trade makes sense. The perfect conditions for this strategy are low volatility and high returns - necessities when yield differentials need to outpace the potential for capital losses. What we have seen today and in the past few months is far from ideal. With the financial crisis spreading, a drop in liquidity has led to a steady rise in volatility. With today's events, the DailyFX Volatility Index rose to 16 percent - recent historical highs. However, risk isn't the only factor in the carry trade unwinding. If returns were great enough to compensate for the risk, the strategy may be able to hold its ground. But, the coordinated rate cut has further reduced already narrow spreads. What's more, with the Bank of Japan conspicuously absent from the global effort, the premier funding currency is further curbing rate spreads. Unless risk stabilizes (volatility pulls back), those carry trade sensitive pairs (EURJPY, GBPJPY, USDJPY, AUDJPY, NZDJPY, etc) will sustain their dive.

DailyFX

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