Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower yielding currencies.
Itís kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better. The same goes for carry trade. Economic conditions may not be good, but the outlook of the buying currency does need to be positive.
If the outlook of a countryís economy looks as good as Angelina Jolie or Brad Pitt, then chances are that that countryís central bank will have to raise interest rates in order to control inflation.
This is good for carry trade because a higher interest rate means a bigger interest rate differential.
When Do Carry Trades NOT Work?
On the other hand, if a countryís economic prospects arenít looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to help their economy.
To put it simply, carry trades work best when investors have low risk aversion.
Carry trades do not work well when risk aversion is HIGH (i.e. selling higher-yielding currencies and buying back lower-yielding currencies). When risk aversion is high, investors are less likely to take risky ventures.
Letís put this into perspective.
Letís say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money?
Your neighbor would probably choose a low-paying yet safe investment than put it somewhere else. It doesnít matter if the return is low as long as the investment is a ďsure thing.Ē
This makes sense because this allows your neighbor to have a fall back plan in the event that things go bad, e.g. he loses his job. In forex jargon, your neighbor is said to have a high level of risk aversion.
The psychology of big investors isnít that much different from your next door neighbor. When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.S. dollar and the Japanese yen.
If you want a specific example, check out Forex Gumpís Piponomics article on how risk aversion led to the unwinding of carry trade.
This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest.