The Carry Trade


February 2014
Ivan Obolensky

Markets in Europe and in the US tanked recently.

The reasons cited were turmoil in Emerging Markets and the unwinding of the carry trade.

Nice to know, but whatever does it mean?

Emerging Markets are countries characterized by rapid growth and industrialization. They include the BRICs (Brazil, Russia, India, and China) and the MIKTs (Malaysia, Indonesia, South Korea, and Turkey) as well as several other countries such as Colombia, Peru, and Chile.1

How about the “carry trade”?

The term “carry” has a specialized definition in trader parlance. It means the total return on an investment although it usually refers to the interest rate generated. For instance, if one buys a Government Bond that pays 4% interest then the carry of that bond is 4%. It can also mean the cost expressed as an interest rate that one has to pay to borrow money. For instance, if one is paying 12% interest on a credit card then the carry is 12%. It can also mean the total interest rate received. As an example, if one borrowed money at 2% and invested it at 7%, the carry would be 5%.

The term, the carry trade, started in the mid nineties but the reasons for it began much earlier in the 1960s when the world’s biggest economy (the US) began to experience a long and sustained period of inflation.2

Inflation is when there is a prolonged rise in prices usually because there is a lot of money about or because there is a scarcity of goods or services. In the case of the US both occurred simultaneously.

Firstly, government borrowing and spending ratcheted up significantly during the 1960s as a result of the Space Program, the Vietnam War, and the Great Society initiatives put forward by both the Johnson and the Kennedy Administrations. Inflation did not necessarily occur because of the nature of these programs, but because the amounts of money needed to finance them and resources required were far in excess of what was available through taxes, or reserves. Many of these programs, including the Space Program were eventually scrapped because they were unsustainable.

Secondly, the baby boomers, which greatly outnumbered all other living generations at the time, were transitioning from children to adults. They entered the work force, started getting paid, and wanted to spend their money on goods which drove up demand and created scarcities.

Thirdly, in 1973, the Arab members of the Organization of Petroleum Exporting Countries decided to create an oil embargo as a result of US involvement in the Yom Kippur War of that year. This raised oil prices which rose from under twenty dollars a barrel to over a hundred, thereby significantly increasing the costs of production.

Discovering what about that particular time period led to the confluence of all these factors is something that will devil economists and historians for centuries to come because the collision is still reverberating through the world and has helped shape the majority of current economic policies and thinking.

When there is inflation it pays to consume because what you buy today will be more expensive tomorrow.

Buy now, even on credit, became the mantra of the ’70s and ’80s.  This behavior created more demand, more scarcity of goods, and more money due to the expansion effect of credit on the money supply thereby accelerating inflation still more.

As a side note, this thinking is still very much with us in the form of societies built on consumerism. But without a sustained inflation, rampant consumerism is not only financially foolish but wasteful. In the face of a deflation (the opposite of inflation) it can be deadly. Consumerism’s lack of real relevance more than likely set in motion its opposite: Do more with less which is the basis for several current social movements including the green movement.

Back to our story: the US Federal Reserve was given the task of getting inflation under control and this they did by raising short term interest rates from around 5.75% in 1971 to 20% in 1981 but with the unintended consequence that most of the manufacturing that was taking place in the United States disappeared or moved overseas. It moved because money from abroad flooded into the United States.  The old rule that money goes where it is treated the best held sway. If you had a choice between a 5% return on your savings and 20% which would you choose? Buying dollars and parking them in US banks earning 20% was a no brainer. As more and more foreigners bought dollars, the dollar in relation to their currencies became more and more expensive. So much so that when US companies tried to sell goods abroad and make money by being paid in dollars they were priced out of the market. At home, goods imported from abroad were much cheaper than those manufactured in the US of the same quality. US manufacturers went out of business in droves or shifted their manufacturing facilities abroad in order to compete.

Japan turned into an export powerhouse (think of the rise of Toyota, Datsun/Nissan, Sony, to name a few) and retained much of their dollars in the US where they were paid excellent returns on their savings with little risk.

Eventually inflation began to subside and interest rates began to drop. The dollar was still high so Japanese assets moved out of high interest savings and into real estate, company acquisitions, and commodities. Japan started to buy up everything US.

In 1985, the Plaza Accord was signed between France, West Germany, the UK, Japan, and the US to depreciate the dollar. It was put together by then Treasury Secretary James Baker because job loss and unemployment was becoming difficult to take politically. The G5 announced they wanted the dollar to drop to about half its current value in relation to the Japanese yen.

Japanese business, seeing the writing on the wall, liquidated as many of their US holdings as possible and repatriated those funds back to Japan.

It is thought that this led to the 1987 crash of the US stock market, although this was never fully proved because mapping the flow of funds to link the event directly to this repatriation was not possible at the time. What was certain was that the Japanese real estate market skyrocketed as well as all Japanese assets as a tsunami of capital returned to Japan to find a home.

Due to trade barriers (no or few imports allowed into Japan ensured no foreign competition) Japanese prices increased and remained sky high. This created such gigantic trade imbalances that Japan became the largest asset bubble in the world. Since Japan started to come under pressure from the US to allow more imports or face tariffs on Japanese goods, it decided to let a bit of the air out of the balloon by tightening monetary policy. The result was a market crash (1989) of epic proportions that in some ways is still unfolding even today. Prices deflated and business expansion shrank to a snail pace. To help stimulate growth, interest rates were dropped to zero to stimulate borrowing thus setting up the environment necessary so we can pick up our story about the carry trade because this is when and where it begins.

The time period is 1995-1998. The interest rate environment is as follows: the US short to medium term interest rates were around 5% while the Japanese rates were effectively zero, or close to it.

In a further effort to stimulate growth, the Japanese Central Bank decided to deflate the yen against the dollar to make investing in Japan even more alluring.3

One often hears of the wizards of Wall Street making millions. How do they do that exactly? Do they buy a boat-load of stocks and hope for the best? They do not; too risky and unpredictable. Instead several successful ones have relied on two fundamental concepts: arbitrage and leverage.

Arbitrage is taking advantage of price differences between the same or similar items in different markets. If gold is selling for ten dollars more an ounce in India than in New York, I can sell the India gold and buy the New York gold and take advantage of the price difference. If the transport charge for shipping an ounce from New York to India is less than ten dollars (say $5.00), I have made a five dollar profit on each ounce I buy and sell. The transaction is virtually riskless provided I buy and sell the same item simultaneously, and there is a settlement time to allow me to deliver the gold to the buyer in India.

Leverage is the multiple effect of borrowing. Suppose in the example above I buy and sell 1,000 ounces. I make $5,000 dollars: too small. But what if I buy and sell one million ounces. The transaction is now worth 5 million dollars. If I am able to borrow the money to buy the one million ounces of gold in New York and convince the lender that I am selling the equivalent amount in India and will replace the cash by wire in three days I have used leverage to multiply my potential profits and made a packet.

This is the holy grail of those who wish to wear expensive suits, colorful suspenders, and power ties.

Let’s imagine you decided to open a hedge fund in 1995 and have 50 million dollars seed money to invest. What do you do? You look for a riskless transaction where you can make a small but guaranteed return, and then you leverage it as much as possible. Where can you find one?

In 1995 the Japanese Central Bank announced a deflationary policy in regards the yen and the dollar with an almost zero interest rate for short term borrowing. If you borrow from them and invest in something that earns a guaranteed return, you can arbitrage the interest rate difference.

Suppose you take that 50 million US dollars and buy 5% US treasuries that redeem for 50 million cash in a year. You are guaranteed 5% return by the US government; so far so good. Now you use those bonds as collateral for a loan from a Japanese bank who gives you 45 million US dollars worth of yen. The bank is willing to loan up to 90% because the US debt is excellent collateral. You convert the yen back to dollars and buy more 5% treasuries in the US. Back to the Japanese bank you go with this new lot of US debt to use as further collateral to buy more yen to convert to more dollars, etc. Do this over ten times and the return rises from 5% to 50% on the original 50 million seed money because of the interest earned on all the US treasuries adds up. You have taken a modest return and then multiplied it by borrowing.

Most hedge fund managers during this time were able to keep up to 20% of the profits as well as charge the client a percentage point or two to manage the money. 50 million dollars in seed money was small. Think several hundred million.

The years between 1995 and 1998 marked the golden age of the carry trade. The yen deflated from 80 to 140 during this time. (One dollar was able to buy 80 yen in 1995 and 140 in 1998) This meant not only did one make the interest rate spread with each cycle of leverage, but one could pay the loans back with less money and keep the difference. For example, the original 45 million dollars worth of yen you borrowed based on the 50 million in US treasuries could be paid back using only 30 million dollars because the loan was in yen and far fewer dollars was needed to pay it back after a year. The hedge fund in this case pocketed the 15 million dollar difference.

This is the carry trade in action and until 1998 the term “carry trade” was virtually unknown except by a few very smart people who made fortunes. It was so successful that many tried to emulate the mechanism.

During this same time, US interest rates decreased and as they did so, it became less profitable to use US treasuries as collateral for Japanese loans. Other sovereign debt instruments (debt issued by other countries) paid higher interest rates and could work just as well provided the currency pairings were stable. If the yen started to appreciate in relation to those currencies, the loans became more and more expensive to pay back.

Between 1995 and 1998 the yen-dollar relationship was predictable because the Japanese currency policy in regards to the dollar was known in advance taking away a major unpredictable factor in the trade.

The carry trade carried on virtually unknown until 1998, when Russia defaulted on their debt.

Currency pairings which were stable and necessary for a smooth carry trade became unstable overnight. The value of government bonds of many countries crashed. In the case of Russia, they went to zero.

As prices dropped, the bonds became insufficient in value to support the loans. Everything and anything needed to be sold to raise cash to create the necessary collateral to cover the loans so they could be paid back and unwound. This included stocks, gold, anything available. Done quickly, a drop in prices can turn into a crash, and it did.

Let us move to the present. What is the interest rate environment? The interest rates in Japan, Europe, and the US are virtually zero so no or little carry there. What about all those BRICS and MIKTs? Suppose you bought the sovereign debt of these countries and used this as collateral for loans from Japan, the US, or Europe? There is carry there, but the currency part of the trade is tricky.4

So how can Emerging Markets influence larger developed country markets? The answer is arbitrage and leverage. Although the carry trade golden age is past, variations exist and when they get unwound rapidly everything gets sold to cover the collateral to unwind the leverage. What triggers this type of move? Rapid and large currency fluctuations can do it as well as a potential debt default. It is something of which to be aware.


  1. Manori, A. (2013) Acronymitis: BRICs, PIIGS and other financial nations. Retrieved on February 10, 1014 from
  2. Dow, M. (2013) You Don’t Really Understand the Carry Trade, Do You? Retrieved of February 10, 2014 from
  3. Armstrong M. (2000) The Best of Princeton Economics International and Martin Armstrong
    1996 – 2000. Retrieved on February 10, 2014 from
  4. Dow, op. cit.



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  1. Margarita Rosa Sierra Beuth
    Margarita Rosa Sierra Beuth02-19-2014

    Gracias Joji e Ivan, compartire este excelente articulo con mi hijo , esta estudiando economía, creo que le va a interesar y a servir mucho! Abrazos Marga.

    • Ivan

      Thank you for your comments. I hope your son enjoyed it. Muchas gracias.

  2. craig houchin
    craig houchin03-08-2014

    Another great article. Thanks for the very clear explanation.

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