When foreign exchange trading meets inflation-targeting self-fulfilling investment strategies are possible. A technical paper by Plantin and Shin shows that positive FX carry encourages capital inflows that reduce inflation and allow monetary policy to condone a domestic asset market boom. Thereby FX carry strategies create their own implicit subsidy and self-validating flows. Conversely, a reversal of such flows is self-destructing.

Plantin, Guilaume and Hyun Song Shin (2014), “Destabilizing carry trades”, Systemic Risk Centre Discussion Paper No 17, October 2014
http://www.systemicrisk.ac.uk/sites/default/files/downloads/publications/dp-17.pdf

The below are excerpts from the paper. Emphasis and cursive text have been added.

The basic idea

“The high Sharpe ratio generated by carry-trade strategies is one of the most enduring puzzles in international finance…This paper offers a theory that relates excess returns on carry trades to…destabilizing consequences of international capital flows…[i.e.] credit flows that may be misaligned with local macroeconomic conditions, and with the objectives of the local monetary authority.”

“Our approach is more closely related to models of financial instability in which speculators earn rents if they successfully coordinate on a collective course of action that triggers a policy response that benefits them.”

“Our theory of carry-trade returns as self-fulfilling genuine excess returns bears little relationship to the existing theories that seek to explain the return on carry trades as a compensation for possibly mis-measured risk (view post here)…We do not deny that a significant fraction of carry-trade returns may reflect risk premia. We abstract from risk considerations here for tractability only, and view our theory as a complement to such considerations rather than a competing alternative.”

The importance of inflation targeting

“Our theory rests on two central ingredients. First, we posit that the prices of the non-tradable goods in this small economy are much stickier than that of the tradable goods… Second, the domestic monetary authority anchors domestic inflation expectations by committing to a textbook interest rule that responds to realized CPI inflation. In particular, the monetary authority responds to carry-trade inflows only insofar as they affect domestic inflation…the central bank does not respond to the asset price fluctuations induced by flows of ‘hot money.’”

“Carry-trade inflows result in a realized inflation that is below target…this deflationary impact of carry-trade inflows must operate through the prices of tradables. If…the fraction of pure tradables in consumption services is small [as is the case in large or closed economies], then small deflationary shocks translate into large swings in tradables prices…and thus into a large appreciation of the nominal exchange rate.”

The consequences for trading strategies

“Overall, the anticipation of future carry-trade activity raises the current return on the carry trade through an appreciation of the nominal exchange rate. On the other hand, current carry-trade activity reduces domestic asset returns and thus negatively affects the current return on the carry trade.”

“There exists an equilibrium in which the anticipation of excessive future capital inflows fuels excessive current inflows. In this equilibrium, the domestic currency keeps appreciating, and the carry trade generates a positive excess return…the interest-rate differential acts as a coordination device among carry traders. Positive shocks on the interest rate differential [such as an unanticipated improvement in local economic conditions] set off dynamics in which capital inflows increase, and the domestic currency keeps appreciating. This generates a prolonged series of positive returns on the carry trade that ends abruptly only after a sufficiently long series of negative shocks on the interest differential leads carry traders to coordinate on large and rapid capital outflows.”

“Because current and future capital inflows reinforce each other, there is also the possibility that carry traders…enter into the self-defeating strategy of lending too little…In sum, there are multiple steady-states when lending by other carry traders makes lending more appealing to each carry trader. This occurs when exchange rate appreciation due to anticipated future lending more than offsets the negative impact of current lending on the real rate.”

“The qualitative properties of these equilibrium paths relate to several well-documented empirical facts, such as the profitability of FX momentum and carry-trade strategies.”