How do carry trade strategies perform in risk-on vs. risk-off environments?

Carry trade strategies perform well during risk-on environments when investors are confident and willing to take risks. But in risk-off environments, when fear or uncertainty rises, these strategies often underperform as investors pull out of risky assets and shift to safer ones.

What is a carry trade strategy?

Carry trade is a strategy where investors borrow in a currency with low interest rates and invest in a currency with higher interest rates. The goal is to earn profits from the interest rate difference, also called the "carry."

It’s widely used in currency trading, especially in the forex market. For example, borrowing in Japanese yen (low interest rate) and investing in Australian dollars (higher interest rate) is a classic carry trade.

How does it perform in a risk-on environment?

In a risk-on environment, investors are optimistic about global growth and are willing to invest in riskier assets. This benefits carry trades because:

• The higher-yielding currencies become more attractive.
• Volatility is low, so the trades are more stable.
• Capital flows to emerging markets and other high-yield economies.

As a result, carry trades often perform very well when the market sentiment is positive.

What happens in a risk-off environment?

In a risk-off environment, fear, uncertainty, or crisis dominate the markets. Investors move their money to safe-haven assets like US Treasuries, gold, or currencies such as the USD and JPY. Here's how carry trades are affected:

• High-yielding currencies lose value quickly.
• Investors unwind their carry positions to reduce exposure.
• Sudden currency fluctuations can cause losses.

Carry trades become extremely vulnerable during risk-off phases due to currency volatility and flight to safety.

Examples of carry trade performance

Let’s look at real-world examples:

• Risk-on (2003-2007): Carry trades flourished due to global economic stability. Currencies like the AUD and NZD appreciated.
• Risk-off (2008 financial crisis): Carry trades collapsed as investors rushed to safe assets. Huge losses were reported.
• COVID-19 crash (March 2020): Sharp unwinding of carry positions occurred globally.

These examples show how carry trades are deeply linked with market mood and global risk perception.

Carry trade strategies can generate steady profits in calm, confident markets. However, they can turn risky very quickly during market panic. Successful carry trade investors closely monitor global events, central bank policies, and shifts in investor sentiment. It's essential to manage risk, use stop-losses, and diversify to avoid major losses in volatile conditions.