Carry and equity markets

A recent argument from a major bank suggests that currency carry trades are tied to the performance of equity markets. The line of transmission between carry and equity markets is an interesting one and more complex than what some may think. Establishing a link may be harder than what one would expect.

How can carry trades be best described? It is actually a combination of two trades. First, it is a pure financing trade. Borrow the low yield and buy the high yielding instrument. This is no different than bond financing trades where you borrow short and lend long, but instead of trading maturity differences, you are trading differences in rate location. Now this is unlikely to be profitable if it was not for the second trade which is the currency component. The second part of the trade is based on the assumption that currency markets are not fully linked to interest rate markets. If there was a strong link, uncovered interest rate parity would hold. We will not go into all of the details for why link is not perfect other than to say that the currency markets are driven by a different set of investors than those in the bond markets. There are not enough cross-over investors to get uncovered interest rate parity to hold.

Given the description of carry trades, there should not be a direct link between carry type trades and equity markets, so you have to dig deeper into this story to find a meaningful relationship. Nevertheless, there may be a relationship through three sets of factors.

One is a risk aversion factor which may be the most creditable. The risk aversion story is based on the idea that if there is an increase in volatility, then there will be a market reaction tied to the fact that market participants are risk averse. There will be a desire to cut positions in high yielding risky currencies. A corollary to this story is that those countries which are lenders and have a balance of payments surplus will bring capital back to their home markets. These countries also happen to be those which have lower yields. Carry trades are tied through risk aversion to higher volatility. Higher volatility will cause both markets to demand a higher risk premium to hold these securities.

The other potential link between carry trades and equity markets is through macroeconomic transmissions which affect nominal interest. Here the analysis gets a little murky because the impact of the business cycle, monetary policy, and inflation may cause equity markets to move at times in opposite directions with carry and at other times in tandem. Look at the simplest case of tighter monetary policy. A central bank placing restrictions on credit will cause short-term interest rates to increase. This may be good for the carry trade but may have a negative impact on equity markets. There can also be situations with interest rates rising from stronger business conditions which will be good for the carry trade and may also lead to strong equity markets. The relationship is more ambiguous.

The third link may be through international equity flows. Under this scenario, relative equity returns between two countries may lead to financial flows which affect exchange rates. These exchange rate changes from financial flows may reinforce carry trades or disrupt the direction of exchange rates associated with carry. Some argue that especially for emerging markets equity flows have a strong impact on exchange rates which could be greater than fixed income flows.

Generalizations of what may happen with carry trade based on equity markets should be looked at with healthy degree skepticism. There has to be an understanding of the root cause of each market move to make a judgment on the relative impact.