Carry trades amplify exchange rate response to policy tightening
A new BIS Bulletin finds that currency carry trade activity can significantly shape the exchange rate response to monetary policy. Significant short positions of carry traders in funding currencies amplify the impact of policy tightening.
Leveraged speculation and policy shocks
The study quantifies the impact of leveraged currency speculation on exchange rate reactions to monetary policy news in carry trade funding currencies.
Carry traders borrow in low interest rate "funding" currencies and invest in high interest rate currencies.
When these funding currencies, such as the Swiss franc and Japanese yen, are heavily shorted by speculators, a domestic monetary policy tightening shock leads to their significant appreciation.
This effect is driven by the unwinding of leveraged carry trade positions accumulated prior to the policy announcement, creating a state-dependent monetary policy transmission to the exchange rate.
Conversely, when carry trade activity is minimal, the exchange rate response is muted due to the absence of a deleveraging spiral.
Swiss franc's erratic shifts reveal mechanism
The research highlights the contrasting reactions of the Swiss franc to comparable monetary policy surprises from the Swiss National Bank (SNB).
Despite similar impacts on domestic interest rates, the franc appreciated sharply around SNB announcements in June 2010 and June 2022, but barely moved around others in March 2015 and March 2020.
This divergence is linked to carry trade activity.
Before periods of strong franc appreciation, speculators were net short on the Swiss franc, indicating leveraged borrowing vulnerable to unwinding.
Speculative positioning in currency futures is used as a reliable gauge of carry trade activity, with large net short positions in CHF and JPY signaling strong global carry trade prevalence.