Funding currency is a term relevant to the currency carry trade, in which investors borrow one currency at a low interest rate and lend in another currency at a higher rate. The currency that is borrow at the lower rate is known as the funding currency.
Q. So, what’s this refer to? Whose currency is funding what?
A. The term relates to the currency carry trade. In a carry trade, someone borrows in one currency, one with a low interest rate, and then uses the proceeds to invest in a country with a higher interest rate. That’s also called a positive carry trade because you’re making money on the interest rate differential. Anyway, the currency you *borrow* in the carry trade is called the funding currency.
Q. OK, now, before we go on here let’s ask why everyone doesn’t do that? Borrowing at 1% and lend at 3% sounds like a pretty good trade.
A. It is, provided that the relative strengths of the currencies involved don’t change. If I borrow in, say, Japanese Yen to invest in Australian Bonds… a typical sort of carry trade… at some point I have to repay the Yen. So my risk is that the Yen appreciates while I’ve got the trade on, so that I’ll need more of them to repay the loan. If that happens, I could easily be a net loser on the transaction.
Q. Right. OK, so with all the central banks pushing their rates down so low, what’s going on with the carry trade right now?
A. Lots of big changes in this market. The Yen’s been the funding currency of choice for a long time, because its interest rates have been so low. But that’s changing now, and folks are using the Euro in a big way. That tells you something important other than just that Euro borrowing rates have fallen. It tells you that traders do not expect the Euro to strengthen… because, as we just said, that would mean big losses for them. It’s an important market sign.
Q. Interesting. So what’s that mean for the Yen?
A. That it’s getting stronger, because people aren’t borrowing it and then selling it to invest in the currencies other countries. Fewer sellers mean a higher value, which is exactly what the Bank of Japan and Japanese exporters don’t want. And of course its a bit of a self fulfilling cycle, because if people think it’ll get stronger, they won’t borrow in it, which makes it stronger…
Q. OK. And just where do the carry traders like to invest these days? With all the big central banks at zero, are there places to invest?
A. That’s changing too. Australia was a very popular place, but now you’re seeing some movement to Poland and Romania, because traders can find nice 8% yields there.