Historically speaking when it comes to interest rates we are at historic low levels among developed economies, and not only that the rates are so low but recently ECB has surprised the market by going negative rates in an desperate attempt to force people to spend more and thus making inflation to pick up. This idea of negative interest rates is intended to reduce the incentive to save money in the bank and thus to stimulate consumer spending.
In this environment it makes sense for investors who are chasing yield to rush in and park their money with the countries that are moving away from this easing cycle and are already starting to raise the main interest rates like: The South African Reserve Bank (SARB). The reason why the South African Rand, an exotic currency, is the perfect candidate for the carry trade strategy is because in the current global macro landscape is the main place where investors who are chasing yield can earn a nice return.
A carry trade is when you buy a high interest currency against a low interest currency. So it make sense to go long high yielding currencies as your broker will pay you the interest difference between the two currencies, as long as you are trading in the interest positive direction. Besides the interest differential gains you can also benefit from the actual exchange rate fluctuation if you’re trading in the direction of carry interest if the exchange rates appreciate.
The underlying SARB’s tone has been hawkish after July rate hike by 25 basis points to 6% and comparing that on the global scale where things are on the opposite side of the interest rates spectrum, as just this year alone more than 25 Central Banks around the world have cut the interest rates at least one time, soon we can realize how attractive the South African Rand can be. Market expectation for another 25 basis point hike in September has also grown considerable after recent move from SARB. Apart from South Africa and Brazil no other Emerging Market Central Bank (see Figure 2) has intention to hike rates, quite contrary they all have been lowering the interest rates in order to stimulate growth in their economies. South Africa interest rates are forecasted to pick at 11% by September 2016.
On the other hand if we look at the global interest rates spectrum, interest rates expectation have been downgraded and even current FED interest rate normalization cycle will be very slow by historical standards. However, one question still remains unanswered: whether or not investor appetite for yield can downplay the spike in global risk aversion, brought by the turmoil in China and spurt the demand for the South Africa Rand. You have to keep in mind that when one employs carry trading strategy the main objective is to capture the yield and not merely to profit from the exchange rates appreciations. This doesn’t mean that you shouldn’t factor in the exchange rates movements because your carry trades can be quickly diluted by a strong trend.