Playing the Carry Trade

On the day when the carry trade has driven the pound over the $2 mark, the Financial Times looks at its spiritual home: Japan. In Japan, household financial decisions are generally made by the wife, which is why investment banks around the world like to talk about "Mrs Watanabe" as the archetypal Japanese retail investor. And Mrs Watanabe has done very well of late, investing in high-yielding currencies such as the Australian dollar.

The idea behind the carry trade is simple: you take (or borrow) money in a low-yielding country, such as Japan or Switzerland, and then invest that money in a high-yielding country, such as Britain, Iceland, or Brazil. This is a strategy, as the FT notes, which normally works until it doesn't:

The further these positions are stretched, the sharper will be the snap back when something panics the markets. The last serious unwinding of yen carry trade positions, in 1998, drove the yen up almost 30 per cent against the dollar in two months.

You don't even need to go as far back as 1998: Just last year, the Icelandic krona plunged literally overnight, wiping out hundreds of millions of dollars in carry-trade gains. But the risk of FX volatility certainly doesn't seem to have stopped Mrs Watanabe from buying bonds which pay out in Aussie dollars – and making a lot of money by doing so.

If this kind of investment seems attractive to you, it's possible, but not easy for a US investor to play. On the other hand, if markets revert to mean, as many long-term investors believe they do, then maybe that's just as well.