Thursday, November 19, 2009

Why Carry Trade Is Profitable In The Long Term

I have hinted or mentioned explicitly several times before (for example here, here and here), high interest rate currencies tend to give a higher return than low interest rate currencies. I will now elaborate on this issue.

In my own compilation of returns for investors (based on 3-month interest rate data from the OECD web site and exchange rate data from the Federal Reserve web site) in the 25 year period between 1984 and 2008 (more strictly between December 31, 1983 and December 31, 2008), investors in the three highest yielding developed countries, New Zealand, the U.K. and Australia got a cumulative return of 885% (9.6% per year), 525% (7.6% per year) and 488% (7.3% per year). By contrast, investments in the three lowest yielding developed countries, Japan, Switzerland and the United States gave the far more lackluster cumulative returns of 371% (6.4% per year), 376% (6.4% per year) and 264% (5.3% per year).

The carry trade strategy of investing in high interest rates countries while not investing (or even borrowing) in low interest rates countries yielded even better results if portfolios shifted each years depending on which countries had high interest rates that year (United States for example had relatively high interest rates in the late 1990s, but had low interest rates after the Internet stock bubble ended). In that case, the average return of the high interest rate countries was a cumulative 795% (9.2% per year) while the average return of the low interest rate countries was just 285 %( 5.5% per year).

Since the currencies of the two countries with highest interest rates among developed countries right now, Australia and New Zealand, has appreciated dramatically this year, the results will probably be even clearer when data from this year is included.

According to the uncovered interest rate parity model taught by universities in international economics classes, these differentials shouldn't exist. But they do, meaning that the model is at least partially false.

The reason for why it is not true is that as I pointed out here, it is not consistent with the purchasing power parity model in a world where real interest rates differ. Remember, exchange rates are determined based both on goods market transactions (which the purchasing power parity model deals with) and asset market transaction (which the uncovered interest rate parity model deals with), and if high interest rate currencies become initially overvalued in goods market terms in accordance with the scenario necessary for the uncovered interest rate, then demand for goods produced there will fall, preventing the currency from rising sufficiently in value for uncovered interest rate parity to hold.

Today's international economics classes fails to integrate theories related to goods markets and capital markets, even though both are involved in determining exchange rates in the real world.

To illustrate these abstract theories with a specific example, assume for example that Australia and Japan have nominal interest rates of 6% and 2% respectively, and assume that inflation in Australia is 2% and 0% in Japan. In order for interest parity to hold, the Australian dollar must on average depreciate by nearly 4% per year against the yen. Since there is a 2% inflation differential, the real depreciation of the Australian dollar has to be 2% per year. To create the expectation of such depreciation, the Australian dollar must now become at least 22% overvalued in terms of the goods market equilibrium. But if the Australian dollar started to become that overvalued then demand for Australian goods, and the Australian dollars needed to buy them, would drop, preventing the necessary Australian dollar appreciation. The initial shift in capital market demand for Australian dollars needed to create the conditions that would make the uncovered interest rate parity theory true will then to some extent be counteracted by goods market actions. As a result, the long term return for investors in countries with high (real) interest rates will be higher than in countries with low (real) interest rates.

Note however that in case high interest rates simply reflects high inflation, then it will not give you a high return, as people who invested in securities denominated in for example Icelandic krona and Zimbabwean dollar are painfully aware of.

And also note that the strategy is not entirely risk free in the short term. Some years, like in 2008, the carry trade strategy will inflict losses on those who follow it. But other years (like likely 2009) the return will be extraordinarily good, and if you have a more long term perspective it will generate higher returns for you.