Carry trades torpedoed the market. They’re still everywhere

• Carry traders hold an asset that offers a predictable income or return (like interest, dividends, or premiums) while funding that position with a lower-cost source, often using borrowed money. Essentially, they’re about cashing in on predictability, making money even when nothing happens.
• While foreign exchange carry trades were in the spotlight last week, there are plenty of other carry trades out there, like betting on low volatility, low correlations, or low credit risk.
• Carry trades are a bit like selling catastrophe insurance. They collect premiums regularly and that feels great – until a rare, catastrophic event comes along and obliterates all their gains.

The latest market turbulence threw a spotlight on one of the investing world’s most popular tactics: the humble carry trade. It uses a strategy that’s beautiful in its simplicity: it thrives on market stability. And though these trades can be impressively profitable, in big numbers, they can also be destabilising for financial markets. So it’s worth getting to know them, so you don’t end up getting broadsided by them.

What are these carry strategies?

Essentially, they’re about cashing in on predictability, making money even when nothing happens. Carry traders hold an asset that offers a predictable income or return (like interest, dividends, or premiums) while funding that position with a lower-cost source, often using borrowed money.

Take, for example, the popular foreign exchange (or “forex”) carry trades. Here, investors borrow funds in a currency with a low interest rate (quite often, the Japanese yen) and invest it in a currency with a higher rate (the Australian dollar, for example, or the Mexican peso). They earn a profit from the difference in interest rates between the two, so long as the exchange rate doesn't swing against them.

But carry strategies aren't just for currency traders. When you buy a stock for its hefty dividend yield, you're engaging in a form of carry strategy. If the market price of the stock doesn't plummet and its dividends are paid out as anticipated, you're in the green with regular, predictable income.

The core idea is that the income – be it dividends, coupons, or some other cash flow – provides a return while the market remains steady. It’s akin to collecting a steady rental income on a property, hoping that its market value doesn't drop. And since the income is relatively predictable but not very high on its own, investors tend to employ substantial leverage to amplify their returns.

What’s the issue, then?

Carry strategies often are portrayed as highly profitable and relatively safe because of that income – and they are, until they're not.

When investors get fearful, when leverage becomes hard to get, or when market conditions abruptly change, the income can start to seem not worth all the risk. And that usually leads traders to unwind their carry positions all at once. Suddenly, those money-making strategies become loss-making ones, as asset prices move, domino-effect selling begins, and leverage amplifies the effects.

So carry strategies are a bit like selling catastrophe insurance. You collect premiums regularly and that feels great – until a rare, catastrophic event comes along and obliterates all your gains. What’s more, these hefty losses typically crash the party at the worst times, like when other markets are spiralling, too. That’s why some folks refer to them as picking up pennies in front of a steamroller.

What are the different types of carry strategies?

Forex carry

Investors in this popular tactic borrow in a low-yielding currency and lend at a higher-yielding one, pocketing the difference in interest rates between the two. The risk is that adverse currency moves (the low-yielding currency rising, and the high-yielding currency falling) might more than offset the interest gains.

For example, shorting the yen to buy Australian dollars has been a popular forex carry trade, delivering stellar returns over the past two years – until earlier this month when the trade unwound, erasing months of profit.

Volatility carry

Investors often pay a premium to protect their portfolios from downturns by buying options or derivatives tied to market volatility measures, like the VIX. The sellers of this "insurance" pocket the premium, betting that volatility will stay low. The “carry” here is the steady income from the collected premiums.

For example, many investors (including major ETF providers) sell “call” options on stocks they own to earn extra income. This strategy is short volatility because it loses out if markets make big moves – whether it's a price collapse, which hurts the stock, or a price surge, which results in losses on the short calls.

Correlation carry

This strategy bets on the stability or movement of correlations between assets, profiting when correlations behave as expected, but losing money when they unexpectedly change.

One big, yet under-the-radar, contributor to the recent market sell-off was the unwinding of “dispersion trades”. A popular example consists of selling the volatility on the S&P 500 index while buying volatility on the individual stocks that make up the index. This trade is a bet that the individual stocks will move more independently of each other (i.e. with high dispersion) than the overall index suggests. As long as correlations among stocks are low, the investor can pocket the difference between the two volatilities.

Credit carry

These strategies involve betting against safe, low interest rate bonds and buying higher-yielding credit instruments – such as corporate bonds, junk bonds, or emerging market government debt. The idea is to profit from the interest rate differential (the "carry") between the two, while keeping your risk from interest rate changes as low as possible. It’s a bet that credit risk will remain low.

Liquidity carry

While it’s not typically labeled as a carry trade, borrowing in highly liquid markets at low interest rates and investing in less liquid, higher-yielding assets fits the carry trade mold. Private equity firms do this when they buy companies using stacks of borrowed money, aiming to earn a higher return on what they’ve bought than they pay for those loans. Similarly, private debt investors raise capital in liquid markets or through bank loans at low rates and lend to private companies at much higher rates.

Other types of carry

Carry trades are everywhere, from commodities (where traders earn by storing goods or profiting from the “roll yield”) to basis trades. They’re at every bank, for goodness sake, where the institution borrows cheaply from the Federal Reserve and lends to everyone else at higher long-term rates. If you bought a property to rent out, you’ve also engaged in a carry trade: collecting rental income while hoping that property values don’t fall far enough to offset what you’ve made. Carry is all about earning more from your investments than the cost of financing them, and it shows up in more places than you might think.

So, what does all this mean to you?

Carry trades are a dominant force in the market, and it’s so crucial that you grasp the risks involved. At first sight, carry trades might look enticing – they can boost returns when economic growth is slow and markets are quiet. These strategies also inject liquidity into the markets, suppress volatility, and promote a sense of calm and stability – which benefits not just investors, but also regulators and central banks. (By the way, central banks might be running the biggest carry trade ever, having bought vast amounts of Treasury bonds with cash.)

Issue is, as financial theorist Hyman Minsky would point out, stability breeds instability. This apparent calm can mask the buildup of risks that remain hidden, often until it’s too late. Case in point: collateralised debt obligations (CDOs) were popular just before the global financial crisis, and they seemed safe until their flaws were catastrophically exposed. Inverse volatility ETFs were top performers until 2018 when they plummeted to zero overnight. Today, there could be similar hidden vulnerabilities, maybe in the opaque world of private markets.

That’s the issue with carry trades: they can seem like a free lunch for years – because the returns are compensation for a small but genuine risk of massive losses, which, may not have materialised yet. But as we saw last week, when volatility does return – often suddenly and violently – carry trades can not only go bust, but can also spark a chain reaction of sell-offs, intensifying market downturns.

Now, not all carry trades are a threat, but when too many folks rely too heavily on them, that can be a red flag, suggesting there are broader market excesses. The longer these trades churn out profits and the more investors depend on them, the more likely it is that the risks become mispriced, market positions become dangerously lopsided, and leverage hits the danger zones. That’s probably why popular carry trades have tended to collapse before a broader crisis, with significant market dips following major carry trade reversals in 1998, 2000, and 2008.

Now the yen carry trade has mostly unwound after last week’s adjustment, but other carry trades – or variations of them – are still prevalent across global markets. And truthfully, it’s hard to imagine the excesses have been fully shaken out.

That said, despite whatever vulnerabilities those trades might have, you don’t have to assume that they’ll soon trigger another financial crisis. Carry trades could be gradually unwound (although that’s not how it usually happens), their losses could be contained, or markets might sustain excesses for a very long period, making it difficult to trade on them.

Still, the yen’s sudden unwind last week does suggest that the era of stability has come to an end, and that we could soon enter a period of greater unpredictability. So you might want to keep your guard up, make sure your portfolio could handle any scenario, and prepare yourself for the possibility of more volatile times ahead.

Stéphane Renevier is a global markets analyst at finimize.

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