Carry trades perform when central banks are either adding interest rates or plan to increase them. In a click of a mouse, people can move money from one country to another, and big investors are not hesitating to move around their money in search of not just high but also increased yield. 

Also, the attractiveness of the carry trade is not only in the yield but also the capital appreciation.

If a central bank increased interest rates, the world would notice, and usually, many people are piling into the same carry trade. As a result, it pushes the value of the currency pair higher in the process. Now, the key is to try and get into the start of the rate tightening cycle and not the end.

Then, the profitability of the carry trades becomes questionable when the countries that offer high-interest rates started to cut them. The first change in monetary policy tends to signal a major shift in trend for the currency. For a successful carry trades, the currency pair either must not change in value or appreciate.

Every time interest rates decrease; foreign investors are less compelled to go long the currency pair and to look elsewhere for more profitable chances possibly. If this happens, demand for the currency pair wanes, and it will start to sell-off.

It is not too hard to know that this strategy fails immediately if the exchange rate devalues by over the average annual yield. Because of leverage, losses can even be more significant, which is why when carry trades go wrong, the liquidation can be disastrous.

The Risk

Aside from that, carry trades will also fail if a central bank intervenes in the foreign exchange market to halt its currency from rising or avoiding it from falling further. And for export-dependent countries, an excessively strong currency might take a big bite out of exports. Then, an excessively weak currency might damage the earnings of firms with foreign operations.

As a result, if the Aussie or Kiwi, for instance, becomes excessively strong, the central banks of those countries might resort to verbal or physical intervention to stem the currency’s rise. And any signal of intervention could reverse the gains in the carry trades.

It is Not Easy

A successful carry trade strategy is not just merely about placing a long currency with the highest yield and a short currency with the lowest yield. Though the current level of the interest rate is essential, the future direction of interest rates is far more vital. Moreover, carry trades only works effectively when the markets are complacent or optimistic.