Comments on:
The Impact of Currency Carry Trade Activity
on the Transmission of Monetary Policy

World Finance & Banking Symposium, Vilnius

Clinton Watkins
Akita International University, Japan

December 2023

Summary

  • Carry is a pervasive factor in currency markets.

    • A deeper understanding would be useful for investors & policy makers.

  • I enjoyed reading the paper.

    • Valuable and robust contributions to the literature.
    • Thorough analysis, logical and well justified.
    • Complex but the authors explained their approach well.
    • Well written.

  • I have a few comments and questions.

Overview

  • A simplification of the approach and results (apologies for any misrepresentation!).
flowchart LR
  subgraph a [VAR model]
  A("FOMC Monetary Policy <br> Announcement <br> (↑ policy tightening)") 
  A ==> B("Conventional <br> Monetary Policy <br> Shock <br> (↑ FF, ↓ SP500)")
  A ==> C("Information <br> Shock <br> (↑ FF, ↑ SP500)")
  B ==> D("↑ USD")
  C ==> E("↓ USD*")
  end
  subgraph b [Threshold VAR model]
  D ==> F("↓ Typical Carry Investment Currency")
  F === G("Depreciate more when involved in the <br> carry trade (high NOI), <br> amplified by flight to safety.")
  D ==> H("↓ Typical Carry Funding Currency")
  H === I("Depreciate less when involved in the <br> carry trade (low NOI), <br> offset by safe haven demand.")
  E ==> J("↑ Typical Carry Investment Currency")
  J === K("Appreciate significantly when involved <br> in the carry trade (high NOI), supported <br> by positive risk taking sentiment. <br> No change if not investment currency.")
  E ==> L("↓↓ Typical Carry Funding Currency*")
  L === M("Depreciate when involved in the <br> carry trade (Low NOI). No change when <br> not used as a funding currency.")
  end
  style a fill:#eaeee7
  style b fill:#d2d6cf

Monetary policy pre/post 2000

  • The sample covers some quite different periods in monetary policy:

  • Are the results robust over these different periods?

  • VARs are interpreted regarding positive FOMC policy shocks. Are the dynamics symmetric regarding negative policy shocks?

  • Are there implications for the shock types and dynamics when policy is below/above the neutral rate?

Figure 1a: Exchange Rates and Interest Rate Differentials.

Red: 12/2003-12/2006, blue: 12/1998-12/2000.

Monetary policy pre/post 2000

Federal Funds Effective Rate 12/1998-12/2000 and 12/2003-12/2006

Monetary policy versus information shocks

  • The authors determine whether an FOMC announcement delivers a conventional monetary policy shock verus an information shock using the reaction in 3-month Fed Funds futures and the S&P500 index, drawing on studies such as Jarociński and Karadi (2020).

    • Monetary policy shock: ↑ FF (yield) and ↓ SP500.
    • Information shock: ↑ FF (yield) and ↑ SP500.

  • The FF reflects an interest rate reaction to for specific maturity at a specific time in the future, while the stock reaction (theoretically) looks forward unbounded by maturity.

    • Yield curve slope can change in response to monetary policy announcements, e.g. higher 3-month and lower 2-year yield when a tightening cycle is expected to peak.

  • Consider a term structure of interest rate reactions to take full account of interest rate expectations at different maturities?

    • Using a policy rate expectation in three months for the monetary policy shock and capturing everything else (information shock) via stock prices may be convenient but it seems an artificial construct. Are rate expectations adequately modelled?

  • Is the post FOMC stock market move a reaction or merely execution of orders delayed until after the FOMC (as a risk event)?

Regime 1, Regime 3…

  • The authors use net open interest (NOI) as a proxy for carry trade activity (in each non-US currency where CFTC futures positioning information is available).

    • A reasonable proxy for carry exposure given the lack of alternatives.
    • However, does not necessarily represent carry as a motivation to trade.

  • Under regime 1 (3), non-US curencies have a relatively low (high) NOI reflecting that they are funding or short (investment or long) currencies against the USD.

  • At the same time, some parts of the paper note that regime 1 reflects low carry trade activity and regime 3 reflects high carry trade activity (in general).

    • I may be confused, but does not regime 1 (3) reflect high carry trade activity for typical funding (investment) currencies?

    • Table 4, Panel B shows the results for when the foreign currencies are in the funding regime (e.g sell JPY and buy USD) and is presented as when there is low carry trade activity.

      • Wouldn’t Panel B reflect the period of high carry trade activity for low yield currencies like the JPY?

Regime 1, Regime 3…

Table 4: Determination of the Currency’s Fundamental Value (authors propose that econmomic fundamentals have explanatory power during periods of low carry trading as the carry trade drives exchange rates away from fundamental valuations).

The Japanese yen

  • Sadly, the $/¥ has a positive reaction to information shocks… (Figs 3 and 4)

    • As does the CHF, also considered a safe haven. The USD is also has safe haven characteristics .

  • On page 15, the explanation says “the results do not contradict the main finding, since these currencies have different risk structures.”

    • However, I wonder how the different risk structures are relevant in the case of a positive information shock since this would enhance the attractiveness of the carry trade.
    • I was hoping for more explanation of the yen’s characteristics given its importance in the carry trade.
    • I found the charts in Appendix D are a little hard to interpret. It would appear the yen has substantial periods in regime 3 but it is unintuitive that the yen would be an investment currency at any time since 1990.
      • Minor point - the charts should be labelled USD/JPY.

The Japanese yen

Figure D1 on regime allocation, only showing the Japanese yen panels.

  • The Threshold VAR regimes: Regime 1 = carry funding currency; Regime 2 = indeterminate region; Regime 3 = carry investment currency.

  • Similarly there are periods in which typical investment or high yield currencies like the AUD and NZD are funding currencies.

  • While their yield differentials may justify the regimes, how much carry was being taken at the time? The risk reward trade-off would not seem to justify it.

    • Does this matter for the model and results, or does it just indicate no carry trading?

Other questions

  • Currency data

    • Several currencies in the analysis are not available directly to offshore investors due to capital controls. Are non-deliverable forward rates used for countries with capital controls?

  • Interest rate data

    • What maturity interest rates are used in the VARs (\(ir^{US}_t\),\(ir^{*}_t\))?

  • Trading strategy

    • Implementable strategy (a potential conditioner for carry exposure? Usually conditioners are based on forecasts for FX volatility or relate carry to value).
    • What currencies do the HML and DOLL strategies gain their performance from? A broad cross-section or is the performance concentrated among certain pairs?

  • The central role of the USD is an appealing feature of this research, but is the USD’s role overstated (set of FX in which futs available)?

References

Akita International University / Clinton Watkins

Belongia, Michael T., and Peter N. Ireland. 2016. “The evolution of U.S. monetary policy: 2000–2007.” Journal of Economic Dynamics and Control 73: 78–93. https://doi.org/https://doi.org/10.1016/j.jedc.2016.09.009.
Boeck, Maximilian, Alina Steshkova, and Thomas O. Zörner. 2023. “The Impact of Currency Carry Trade Activity on the Transmission of Monetary Policy.”
Campbell, John Y., Carolin Pflueger, and Luis M. Viceira. 2020. “Macroeconomic Drivers of Bond and Equity Risks.” Journal of Political Economy 128 (8): 3148–85. https://doi.org/10.1086/707766.
Jarociński, Marek, and Peter Karadi. 2020. “Deconstructing Monetary Policy Surprises— the Role of Information Shocks.” American Economic Journal: Macroeconomics 12 (2): 1–43. https://doi.org/10.1257/mac.20180090.
Mankiw, N. Gregory. 2001. U.S. Monetary Policy During the 1990s. Working Paper 8741. National Bureau of Economic Research. https://doi.org/10.3386/w8471.
Shapiro, Adam, and Daniel J. Wilson. 2019. “The Evolution of the FOMC’s Explicit Inflation Target.” FRBSF Economic Letter, no. 12 (April). https://www.frbsf.org/economic-research/publications/economic-letter/2019/april/evolution-of-fomc-explicit-inflation-target/.