Carry and story-telling

In a RBS FX Strategy piece “The carry trade that wasn’t” Adrian Schmidt notes that the carry trade is related to the change in spreads across countries and to equity premiums. He presents some suggestive graphs on the correlation between the changes in exchange rates and the level of interest rates. He contrasts this with a graph on the correlation between exchange rates and the change in spreads. His argument is that, currently, the carry trade is more dependent on the change in yield spreads than the level of rates. This is an interesting argument but misses the point on the driver of carry-type trades.

The monetary relationship is not discussed. Why would yield spread increase in a country? It could be because there is a tightening in monetary policy. This would raise interest rates and cut the supply of money which from a simple monetary model will have the impact of causing a currency appreciation. The carry type trade is related to monetary conditions which should show up in the yield spreads.

The author also shows that carry trades are related to the movement in stock markets. While not made, the argument for this relationship could be through the business cycle. If there is a rising stock market, it could be associated with surprises in the growth rate of the economy. This will cause an increase in the demand for money. A increase in money demand will lead to an appreciation of the currency. There are no surprises here. Carry type trades are suggestive a macroeconomic relationship which could be the root cause of the currency movement.

The carry trade is a market representation of other factors which are not often observable in real time. It is a combination of market views concerning the underlying variables that drive the economy. We would also suggest that change in exchange rates relative to carry can also be explained by the consumption risk asset pricing model as described in our last posting. The mystery of carry is not that it occurs but why investors do not focus on the macro-events surrounding carry returns.