Carry Trade - When Central Banks Work for Your Profit

Despite the fact that carry trade operations are available mainly to large market participants, their actions can become a pleasant surprise for us, as well as an unexpected trick, in case our trading instrument is a currency pair, which includes a funded currency.

What is the profitability of carry trade operations?

When interest rates on bonds or deposits in a country begin to rise due to actions taken by the Central Bank, hedge funds, corporate currency dealers, management companies and other financial market participants try not to miss the moment to take advantage of this circumstance. The most common are carry trades.

Operations carry The currency trades represent Borrowing one currency at a minimum interest rate and then converting it to another currency and depositing it at a higher rate, or buying an income asset, an example of which would be high-yield bonds, stocks of companies or commodity futures. The currency of the borrowing is calledfunding currency". Often the property of funding arises not only because of low interest rates, but also because of the surplus trade balance of the country.

If there is active interest in the market for earnings from carry trade transactions, the volume of trades being conducted grows, which in turn can lead to a bullish trend in the more profitable currency and a bearish trend in the funding currency. These trends will continue as long as market participants are confident that one central bank will continue its policy of high rates, and that the regulator whose currency serves as a funding vehicle will maintain its stimulus measures.

Intermarket linkages

[info_block align="right"]Central bank policy answers the question why, and intermarket analysis will answer the question where.[/info_block]

The inter-market correlation of funding currencies, high-yielding currencies and stock indices, as well as commodity market instruments and commodity currencies, is extremely high. In my opinion, these connections need to be clearly understood in order to understand the true picture of what is happening in the markets. To do this, you can use some clues or indicators that will help to determine more accurately the current picture of where the money is going and why. Central bank policy answers the question of why, and inter-market analysis will answer the question of where.

The growth of stock indices and commodities during the period of stimulus programs takes place against the background of declining prices of funding currencies, but any trend tends to end or at least there is a risk of a deep correction. At these moments you need to be on your guard, because capital outflows from the stock market will contribute to the growth of funding currencies. And here we face a question: how to track the changes in the stock markets? Let's look at the example of the Japanese yen and stock indices.

Modern asset correlation

Recently and for a very long time There is a very tight inverse relationship between the funding currencies correlation. This means that when the risk appetite grows, which is reflected in the growth of stock indices, we can see a decline in the JPY exchange rate. Accordingly, when there is a sharp fall in the stock markets, we will observe a jump in quotations in pairs, where the yen is present - in this case its rate will rise.

Such stock market collapses can occur as normal corrections, which are unlikely to have much effect on the technical structure of a stock index, or they can bring panic to the capital markets, which in turn can turn into a reversal of the stock market trend. In order to understand whether this is a trend change or still a correction, you need to pay attention to some clues.

The clues will be the intentions and actions of the Central Bank of the country whose stock index is in question, or the data of the commodity exchange on the behavior of major market participants. In my opinion, both of these events are highly correlated.

Interest rates, the Central Bank and stocks - how does it work?

Let's start with the actions of the Central Bank, because they are the main driving force in the markets.

• [info_block align="right" linkText="Fundamental Analysis and Central Bank Monetary Policy" linkUrl="https://mr-trader.com/learn/fundamentalniy-analiz-forex/fundamentalnyj-analiz-foreks-i-denezhno-kreditnaya-politika-cb-kotoraya-opredelyaet-trendy" imageUrl="http://files.fortrader.org/uploads/2016/09/statistics-730×364.jpg"]Monetary or monetary policies of central banks determine the basic direction of trends in the foreign exchange market . Interest rates influence investor interest in a particular currency. Talk about it.[/info_block]

  Low interest rates are a stimulating measure that spurs the growth of the stock market - the shares begin to rise in price.

• → Low cost of credit boosts corporate growth and generally increases some of the most important macroeconomic indicators, such as inflation, employment and GDP.
• → This, in turn, spurs investors, fund managers and private traders to buy stocks in the hope that higher economic growth will contribute to higher corporate profits, making equity investments most interesting.
• → Hence we see a rising trend in the stock markets of those countries whose central banks are pursuing a stimulative policy.

However, at the moments when the regulator gives signals to change the policy of low rates to the opposite, traders will strive to fix the available profit, which was formed on the exchange rate difference. This leads to corrections or even a change of the trend. At these moments, as described earlier, the rate of the currency of funding begins to rise.

A high interest rate policy is unlikely to serve as a reason for rising stock prices at a time when credit is becoming more expensive. At such times there is a desire to accumulate more than to spend, such logic will be relevant for both market players and corporations, which will obviously follow a belt-tightening course. Over time, rising interest rates will lead to some increase in unemployment, lower economic growth and lower inflation. Under normal conditions, this would be a kind of cooling of overheated economic growth, a measure, one must admit, that is necessary, and therefore regularly manifested in different countries.

In a nutshell

So, to summarize: the stock market is in a growth phase with soft monetary policy, which is accompanied by low rates and all sorts of stimulus programs. In this scenario

[info_block align="right" linkText="How to determine a trend reversal using fundamental analysis?" linkUrl="https://mr-trader.com/learn/fundamentalniy-analiz-forex/kak-opredelit-razvorot-trenda-po-fundamentalnomu-analizu" imageUrl="http://files.fortrader.org/uploads/2015/08/fundamentalny-analiz-razvorot-trenda.png"]Central banks, monetary policy and trend reversal. How to determine a trend reversal in Forex using fundamental analysis?[/info_block]

funding currency will be tightly and inversely correlated.

If the stock market corrects or changes the trend at all, stocks will be under pressure and funding currencies will rise. Corrections can be triggered by the publication of macroeconomic indicators, which will lead to the growth of funding currencies in the moment, but these will be short-term trends.

With a global change of trend in the stock market, that is, a decrease in the latter, the currency of funding begins its growth, but it will be more prolonged. It is possible to distinguish a correction from a trend change only through understanding whether the central bank policy will change or not. One way to detect this is by observing macroeconomic indicators.

As you can see, carry trade is quite economically sound and is a real way to make money with a close watch on the market, interest rates and macroeconomic statistics.