Economic circumstances may not be favorable, but the purchasing currency’s outlook must be favorable.
If a country’s economic outlook appears as good as Angelina Jolie or Brad Pitt, chances are the country’s central bank will have to raise interest rates to control inflation.
This is beneficial to the carry trade because greater interest rates result in a larger interest rate differential.
When Do Carry Trades NOT Work?
On the other hand, if a country’s economic chances aren’t promising, no one will be willing to take on the currency.
Particularly if the market believes the central bank will have to lower interest rates in order to assist the economy.
Simply stated, carry trades work best when investors have a low-risk tolerance.
Carry trades are ineffective when risk aversion is strong (i.e. selling higher-yielding currencies and buying back lower-yielding currencies).
When risk aversion is high, investors are less likely to take risky ventures.
Let’s place this in context.
Assume that economic conditions are difficult and that the nation is currently in a recession. What do you believe your neighbor’s money would be used for? Your neighbor would most likely choose a low-paying but safe venture and invest it elsewhere. It makes no difference if the return is poor if the investment is a “sure thing.”
Finding yield is no longer a top concern. It is primary preservation.
This makes sense because it provides your neighbor with a backup strategy in the event that things go wrong, such as if he loses his job.
Your neighbor is said to have a high degree of risk aversion in forex jargon.
The psychology of large investors isn’t all that different from that of your next-door friend.
When the economy is uncertain, investors prefer to put their money in safe haven currencies with low interest rates, such as the US dollar and the Japanese yen.
Check out Forex Gump’s Piponomics article on how risk aversion led to the unwinding of a carry trade for a particular example.
This is the inverse of carry trade. Because of the inflow of money into safe commodities, currencies with low interest rates appreciate against those with high interest rates.