Turkish Lira, Indian Rupee, and South African Rand emerging as the next big plays in the carry trade

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Daniel Kraft's picture

The key to identifying the next big plays in the carry trade will be to select currencies with persistent future interest rate differentials[1]given the projected macroeconomic and geopolitical environment. This environment, in my opinion, will continue to be characterized by monetary policy normalization in the US, an extensive Japanese QE program[2], substantial QE measures by the ECB[3], and structural shifts in the crude oil market that have led to a steep decline of crude oil prices[4]. Given this particular macroeconomic and geopolitical backdrop, carry trades financed in Japanese Yen with the Turkish Lira, Indian Rupee, and South African Rand as the long currencies stand out as the three next big plays.

The increased use of the Yen as a financing currency is the first central theme of these three next big plays, as the monetary policy divergence between the U.S. and Japan continues. The ending of QE3, prospects of a more hawkish Fed, and expectations of policy normalization have led to three bouts of steep USD appreciation in the past two years. This foreign exchange activity has led to losses for carry trade investors as an appreciation of the financing currency USD offsets the trade’s interest rate gains. Now, as prospective carry trade returns for multiple currencies have thus become negative[5], investors have increasingly retreated from the use of USD as a financing currency.

Yet, the Yen offers a compelling substitute as a source currency[6], as Japan’s monetary policy regime is “only expected to ease further”[7]. Japan’s extensive QE program, aimed at lifting the country’s economy out of deflation and stimulating economic growth, was expanded in October 2014 and currently involves a yearly increase of Japan’s monetary base by JPY80tn, achieved mostly through the large-scale purchases of Japanese government bonds. The Japanese QE program is combined with a very low policy rate of 0 – 0.1%, providing for a substantial interest rate differential to higher-yielding currencies. These policies have also resulted in a strong depreciation of the Yen, which has lost over -33% against both the dollar and the Euro since late 2012[8].

The depreciative trend of the Yen and the record-low borrowing rates are expected to remain a key feature of the global macroeconomic reality going forward. First, as the Bank of Japan will likely not succeed in raising inflation to 2% by April 2015 and as the sales tax increase in 2014 has impacted Japanese economic growth more negatively than expected, a continuation of Japan’s ultra-easy monetary policies in the intermediate term is highly probable. Japan being a large oil importer[9], the recent drop in oil prices can also be expected to put downward pressure on headline inflation, further increasing the likelihood of continuing easy monetary policy in order to raise inflation. Second, the BofJ’s easy monetary policies are also expected to be complemented by a variety of fiscal stimulus measures aimed at fighting deflation by stimulating demand, such as the already announced delay of the sales tax increase[10], which should further reinforce the Yen’s current trend[11]. Third, the Yen’s downward tendency will likely be further exacerbated as Japanese investors begin to shift funds overseas, led by the government pension fund GPIF, which announced in October 2014 that it would reduce its holdings of Japanese bonds from 60% to 35% in favor of foreign equities and bonds[12]. Hence, this expected depreciative trend, along with the substantial interest rate differential to higher-yielding currencies, make the Yen an attractive source currency.

In addition to the increased use of the Yen as a source currency, the economies of Turkey, India, and South Africa are set to benefit from the current macroeconomic and geopolitical backdrop in such a manner that their positive carry to Yen will persist as monetary policy expectations in these countries will remain stable and as the long currency will be neutral or appreciative to the financing currency. These currencies currently have substantial interest rate differentials to the Yen, driven by the record-low Yen borrowing rates and policy rates of 8.25%[13], 8.0%[14], and 5.75%[15] in Turkey, India, and South Africa, respectively. We believe that these interest rate differentials will continue to persist in the future and that the profitability of a Yen carry trade into these currencies will not be adversely affected by exchange rate developments for the following reasons.

First, Turkey, India, and South Africa are all three large oil importers that now face meaningfully lower energy import prices as a result of the recent oil price activity[16].

Consequently, we expect lower current account deficits and downward pressure on headline inflation as well as improvements in domestic demand, industrial production, and GDP growth driven by higher disposable incomes and higher profit margins due to lower energy costs. According to the IMF, Turkey’s, India’s, and South Africa’s current account deficits currently stand at 5.9%, 2%, and 5.7% of GDP, respectively, and are projected to stay roughly unchanged over the next 5 years[17]. During the last period of sharply lower oil prices, South Africa’s and Turkey’s current account deficits improved significantly, which we also expect to happen under the current oil price environment. Inflation in Turkey, India, and South Africa is currently estimated at 9.0%, 7.6%, and 6.3%, respectively, and is projected to stabilize in the 5-6% range in the next years[18]. Headline inflation in all three countries should be positively impacted by lower crude oil prices, as can be seen from the sharp drops in inflation in South Africa and Turkey during the last period of sharply lower oil prices. Lastly, the World Bank also expects GDP growth to accelerate in all three countries. This trend should be strengthened further by lower energy import costs, which directly affect GDP growth by increasing domestic demand and industrial production, as they lower fuel, heating, and manufacturing cost and thus increase both consumer’s disposable incomes as well as manufacturer’s profit margins.

World Bank GDP Growth Estimates[19]












South Africa




Second, the economies of Turkey, India, and South Africa are also set to benefit from the current macroeconomic backdrop as large shares of their exports go to Japan and the Euro Area. Easy monetary policies in both regions are expected to have substantial wealth effects by raising asset prices, which in turn is expected to lead to increased demand from the two regions. Furthermore, as both the Euro Area and Japan are oil importers, the decline in oil prices functions like a “tax cut” to consumers and domestic producers, lowering their fuel, heating, and manufacturing costs and leading to increases in disposable incomes, consumer confidence, and producer confidence. For example, oil-based energy costs comprise over 5% of consumer spending in both Japan and the Euro Area, respectively[20]. Hence, the current macroeconomic backdrop can be expected to boost Euro Area and Japanese demand for Turkish, Indian, and South African exports, thus further benefitting their current account balances, GDP growth path, and currencies.

Lastly, as a result of declining oil prices and increased foreign demand, we also expect stable to appreciating exchange rates driven by improved terms of trade, better trade balances, and contained inflation expectations in Turkey, India, and South Africa. In fact, the recent decline in oil prices and the expansion of the Japanese QE program have actually been accompanied by a strengthening of TRY, INR, and ZAR vs. the Yen. This stable to appreciative trend vs. the Yen is expected to continue going forward, driven by the positive fundamental effects of lower oil prices on the economies and currencies of Turkey, India, and South Africa and the continuing downward tendency of the Yen.

As a result of stronger economic growth, contained inflation, and a stable currency, the monetary policy outlook for Turkey, India, and South Africa is stable, with significantly tighter or looser policy stances not overly likely. As a deterioration of economic growth in these three economies is unlikely, the probability of more accommodative monetary policies is low; similarly, as inflation is projected to stay contained, the probability of significantly tighter monetary policy regimes is also low. Hence, we expect the central banks of these three countries to keep policy rates at or around current levels in the intermediate term, thus preserving the interest rate differential to the Yen. As argued above, we also do not foresee adverse foreign exchange effects on our prospective carry trade returns. For these reasons, we see carry trades financed in Yen with TRY, INR, and ZAR as the long currency as the three next big plays in the carry trade.


[16] The recent oil price activity is resulting from structural shifts on the supply side of the market, reflecting OPEC abandoning supply management, increased U.S. crude production and lower U.S. imports leaving spare global supply, as well as continued stable oil production in crisis-ridden Iraq and Libya. Hence, we do not view the current oil price activity as a temporary development and do not expect a meaningful upward correction in the intermediate term. Hence, Turkey, India, and South Africa as crude oil importers stand to benefit from this price environment for a considerable time.