The long-standing strategy of carry trade on the world's financial markets looks set to continue despite some opinions it will moderate due to the ongoing shake-up in the markets.
Carry trade, which uses low-yielding currencies to buy higher-yielding currencies or assets, works more easily with less volatility when markets and currencies are relatively stable and predictable. Many commentators had believed that the trading strategy would largely disappear following the global credit crunch.
As market volatility surged to 10-year peaks and sharp swings wiped out returns made on yield differentials following the credit crisis, many trend-following funds and traders unwound carry trades and some are still nursing their wounds.
The Japanese yen carry trade has survived the past nine months of financial market turmoil with only a slight fall in volumes. Japan's ultra-low interest rates mean that even when global markets hit a difficult period, the basic logic of shifting funds abroad to bet on higher returns still holds for Japanese funds and households alike. Favourite carry trades from the Japanese perspective include the Australian and New Zealand dollars. This is due to very high short-term rates in both countries, which are currently in excess of seven per cent.
Against expectation, during the severe market volatility in the credit crisis between August 2007 and March 2008, Japanese players invested on falling foreign stocks and currencies as a buying opportunity. During this period, Japanese brokerages, life insurers and mutual funds bought a net of $94 billion (Dh345.26bn) of foreign stocks and bonds. This was only slightly less than in the same period a year earlier.
Analysts find it hard to see how Japanese rates will ever increase high enough to entice investors to keep funds domestically. This situation is also supported by the fact that households hold substantial amounts in no-interest cash and deposits. Adding to the trade flow are day-traders in currencies who make leveraged bets with borrowed funds.
Despite some short periods when the yen rises in value, the selling of yen and holding long positions in higher-yielding currencies has been profitable.
Concern about the United States economy and rising inflation pressures will restrict carry trades to some extent. Once markets recover, the yen is expected to be seen as a strong sell.
Looking ahead, as markets stabilise, the volume of carry trade is expected to rise.
Low-yielding currencies such as the yen and Swiss franc tend to attract flows during periods of uncertainty as the low interest rates reflect capital surpluses in their respective countries.
Emerging markets are also a favourite of carry trades. High-yielding emerging market currencies such as the Turkish lira and the South African rand experience relatively heavy trading volumes. The strategy can be very profitable providing the high-yielding currencies hold their value reasonably well.
The number
$94bn: Worth of foreign stocks and bonds bought by Japanese brokerages, insurers and mutual funds