When it comes to deciding where to invest their money, investors will not only
assess the rate of return, but also the economic conditions and political stability of
the country which holds the assets. Generally speaking, developed countries that
offer relatively high interest rates are those which tend to experience decent
economic growth and expansion, which may in turn attract more foreign
investment into their country. An economy that is doing reasonably well will more
likely be able to pay high interest rates to investors. However, it is not just the more
developed countries that may offer high interest rates; many emerging economies
may do so as well, simply because they tend to experience higher inflation. These
are generally not countries where most investors will park their money due to the
high level of economic instability.
Political stability is also another aspect that investors are concerned with because a
politically stable country will provide a good framework for trade and investment.
Adverse economic and/or political conditions could have a negative impact on
foreign investment in the country, and may cause investors to move their assets out
and convert the high-yielding currency into their local currencies, thus resulting in
depreciation in exchange rates of the carry pair.
Widening interest rate gap
The wider the difference in interest rates between the two currencies in a pair, the
higher the interest that will be paid to traders who long the carry pair (with the highyielding
currency as the first currency in the pair) over a period of time. And the
higher the interest fees that will be paid, the more it will attract other traders or
investors to enter carry trades, thereby potentially pushing up the value of the highyielding
currency further as demand for it increases.
On the other hand, a narrowing interest rate gap between the two currencies will
cause traders and investors to lose interest in holding their carry trades and
discourage more people from joining in the carry trades as the interest fees paid out
will decrease. Such a scenario can occur when interest rate hikes are expected to
take place in the country of the low-yielding currency, thereby lifting the currency
from the current low interest rate, or when interest rates are expected to be cut in
the country of the high-yielding currency.
So as a rule of thumb, the wider the interest rate gap exists between the two
currencies, the higher the likelihood of a profitable long-term carry trade.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
