Commentary: Carry trade comes to an end

One of the most popular trading techniques used by forex traders is known as the carry trade. The goal of the carry trade is to find two countries with vastly different interest rates, and profit by buying the currency of one and selling the currency of the other. This trade is popular precisely because it is safe and somewhat predictable. By borrowing in denominations of the lower-yielding currency and lending in denominations of the higher-yielding currency, a savvy investor can capture a spread equal to the interest rate differential, as long as the values of the currencies themselves do not change. Towards this end, most of the talk in forex markets over the last year has focused around interest rate differentials.

However, the prominence of the carry trade is coming to an end for the time being, since Japan and the EU have begun to raise interest rates and erode the profits of carry traders. If forex traders are to survive this period of narrowing interest rate differentials, they must become more creative. In short, it means they must stop focusing on interest rates, and begin focusing on currency fundamentals, such as economic indicators and the actual supply & demand relationship for particular currencies.
The currencies of many emerging markets represent strong candidates on both fronts. Brazil, Mexico, Eastern Europe, India, SE Asia, have all witnessed rapid appreciation in the values of their currencies on the heels of a global economic boom. Many of these nations have implemented important structural changes to their economies and have begun to see prolonged periods of political stability. This has resulted in an improved investment climate, and foreign companies have been quick to capitalize through portfolio and direct investment. This, in turn, has driven increases in productivity and exports, spurring economic growth, which only makes foreigners even more eager to invest. Since the respective money supplies of each of these countries are quite small, all it takes is a slight uptick in foreign capital inflows to drive significant appreciation in the value of their currencies.