Variations in Global Interest Rates
The developing economies are currently at historically low interest rate levels, but in 2014 the (European Central Bank) ECB surprised the market by initiating negative rates in a desperate attempt to force spending and spur inflation. The hope is that negative interest rates will reduce the incentive to save, and instead stimulate consumer spending.
In this environment, it makes sense for investors who are chasing yield, to park their money in the countries which are moving away from this easing cycle and are instead starting to raise the interest rates. One such state doing this is South Africa; with the South African Reserve Bank (SARB). The South African Rand (ZAR), an exotic currency, is the perfect candidate for the carry trade strategy because, in the current global macroeconomic landscape, the ZAR is the right place for investors who are chasing yield and can earn a nice return.
What is a Carry Trade?
A carry trade is when you buy a high-interest currency against a low-interest currency. In this case, it is profitable to trade long on high yielding currencies, as your broker will pay you the interest difference between the two currencies, as long as you are trading in the positive interest direction.
Besides the interest differential gains, traders can also benefit from the actual exchange rate fluctuation as long as the trade is in the direction of carry interest, as long as the exchange rate appreciates.
The underlying SARB’s tone has been hawkish after the July 2015 rate hike by 25 basis points to 6%. Comparing that globally, during this year alone, more than 25 Central Banks have cut the interest rates at least one time. This highlights how attractive the South African Rand can be to foreign investors looking to profit from the carry trade.
ZAR Rate Changes (2016)
The market expectation is for another 25 basis point hike in September has also grown considerably after recent moves from SARB. Apart from South Africa and Brazil, no other emerging market central bank (see Figure 2) has the intention to raise rates. On the contrary, they all have been lowering their interest rates to stimulate growth in their economies. South Africa’s interest rates are now forecasted to hit 11% by September 2016. Update: The highest the SARB interest rate reached in 2016 was 7% on March 17, and the following interest rate changed started to decrease the rate. There was no interest rate change in September 2016.
Global Rate Changes (2016)
On the other hand, if we look at the worldwide interest rates spectrum, interest rates expectations have been downgraded, and the United States Federal Reserve (FED) has indicated that historical standards will prolong interest rate normalisation cycles. However, one question remains unanswered: whether or not the investor appetite for yield can downplay the spike in global risk aversion, brought by the turmoil in China, and spur the demand for the South Africa Rand.
Is the Carry Trade Profitable?
For a time there was a question if the carry trade does offer realistic opportunities in trading, but 2012 research suggests that it does (source: Wall Street Journal) even though the debate continues citing the inevitable bust because of the instability that can affect the markets.
The Yen as a Carry Trade Currency
The Yen is also a popular carry trade currency and warns of casualties on the horizon. Tim Lee, of Pi Economics, is quoted as saying in 2007 that “as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply, making the trade unprofitable, there could be hell to pay in the markets” (Source – Economist -2007). With present market conditions, I think the concern is warranted and still applicable all these years later. But should we trade it, yes, we should, provided JPY’s long-term history of negative interest rate (Source: New York Times).
When a trader employs a carry trading strategy, the primary objective is to capture the yield and not merely to profit from the exchange rates appreciations. This doesn’t mean, however, that you shouldn’t factor in the exchange rates movements because a definite trend can quickly dilute your carry trades.