Interest Rate Differential
An interest rate differential is a difference in interest rate between two currencies in a pair. If one currency has an interest rate of 3 percent and the other has an interest rate of 1 percent, it has a 2 percent interest rate differential.
If you were to buy the currency that pays 3 percent against the currency the pays 1 percent, you would be paid on the difference with daily interest payments.
This simple definition is known as the carry trade earning carry on the interest rate differential. However, developments in 2016 have brought interest rate differentials to a new light that are worth understanding.
Negative Interest Rate Policy (NIRP)
There was been a sharp divergence between developed market economies interest rates and emerging market economies interest rates in 2016. Developed market economies have taken their interest rates below zero to try and spur demand, while emerging market currencies raised their interest rates, trying to limit capital outflow and economic instability. In February of 2016, the Bank of Mexico (Banxico) held an emergency meeting to raise their borrowing rate by 50 basis points while selling US dollars at the market to spur demand for the following Mexican Peso.
While this widens the interest rate differential between the United States and Mexico, it is also a sign of the market of instability or possible desperation by central banks to prevent the global economy from spinning out of control.
The Carry Trade
Forex traders are looking to make the most of the negative interest rate policy with the carry trade. They do this by selling euros or Japanese yen (whose current interest rates are negative) and buying emerging market currencies like that of the Indian rupee, South African Rand, masking Peso, or Turkish lira.
However, these trades, which on paper have very large interest rate differentials, could easily end up being the riskiest trades (if the economic pain found in emerging market currencies continues or becomes more severe).
While the carry trade does earn interest on the interest rate differential, a move in the underlying currency pair spread could easily (and has historically) fall risk sentiment wiped out the benefits of the carry trade.
The old saying that, 'if it looks too good to be true, it probably is' can apply to interest rate differentials. In other words, when interest rate differentials widen too much, it has done so because the risk is seen as threatening to the borrowers in those countries.
Therefore, if you are a new Forex trader was just heard about the carry trade, proceed with caution especially if you see negative interest rate currencies as attractive selling currencies and emerging market currencies as attractive buying currencies. The continued carnage in commodities and uncertainty around China continue to put pressure on the highest yielding currencies. At the same time, the introduction of negative interest rates, as well as uncertainty about quantitative easing's future, continue to see money flow to Haven assets which often have the lowest or negative interest rates.