In theory at least, the carry trade should not exist. But theory and practise often diverge and even more so in the FX markets. Carry is what you make from the interest rate differential between two currencies. Currencies are money and money bears interest, so if you borrow (go short) in a lowyielding currency and invest (go long) in a high yielding currency, you will receive positive carry (or interest). In other words, you would gain even if the exchange rate goe nowhere. In practice, fl oating exchange rates never stand still, so the risk is that what you gain on the carry you may lose on the exchange rate.
I say the carry trade should not exist, because the theory of uncovered interest rate parity should mean that the anticipated interest rate gain should be offset by a currency depreciation. However, the pursuit of positive carry leads to a depreciation of the lower interest rate currency (as investors sell) and an appreciation of the higher yielding one. This makes it very susceptible to herd-like behaviour. In other words, sharp movements as investors rush to exit. The often used saying is up via the escalator and down the lift-shaft.
The Brazilian real stands out amongst the more major currencies as the long carry candidate, which is one reason why it has performed relatively well this year. The real has notably outperformed over the past 6 months, up around 10% against the dollar at a time when other LATAM currencies have languished. Even after the Fed rate increase, this year has been the year for carry trades to outperform. This follows what has been a pretty terrible time for carry, which used to be seen as the ‘no-brainer’ trade before the fi nancial crisis, offering fairly consistent profi table returns for longer-term investors.
So it is investor’s appetite for yield and with it, also return, that has supported the real at a time when the economic fundamentals have remained pretty dire. When the market was putting a lot of faith in a change of leadership and the real rallied earlier this year, I was sceptical that it would last. I’ve been proven wrong on that, but as always, you can be wrong for the right reasons, if that makes sense and I take comfort from that. But beware the tendency for investors to rush for the exits, because if that happens, things could get messy.