Question about the carrytrade

Hello, I would like to see if I have understood some details regarding the carry trade correctly - it's regarding how capital flows, stock and bondmarkets relate and intertwine, for example in the case of an unexpected hike of rates in a country with an already highyielding currency.

If interest rates in country A are low, and interest rates in country B are high, then investors will (if they're willing to take on risk, ie. "risk appetite" is high), then they might borrow funds in county A and place them in bonds in country B. This will tend to push the value of currency B higher - and currency B should be taken higher immediately if an unexpected hike in rates is announced.

Now, this fits well with bonds.

Regarding stocks, an unexpected rate-hike is normally negative - I believe - do you agree with me on that? (Higher rates: higher borrowing costs for companies and thus lower expectations to future earnings of the various companies. (Also, from a theoretical view-point, higher rates means that future earnings are being discounted at a higher rate to find the correct value of a share)

Now - these two effects seem to be working against eachother in the case of an unexpected hike in rates in country B. Capital would FLEE the stock market, and ENTER the bond market.

In most countries, the BOND markets are much larger than the STOCK markets - I believe - do we agree that this is generally true? As far as I know, this is true of USA, Japan, UK, EU and most other economic areas.

Do you agree with my description of how these mechanisms work together?

Can you think of any countries where stockmarkets are larger than bond markets - and does the currency of that country behave "oddly" somehow?

Not sure how well formulted the quesiton is - really, I'm just looking for someone who can give me some insight in how capital flows in and out of stock and bondmarkets are connected to currency values.

Thanks a lot for any comments/answers!

These are massive questions for the average currency trader and broadly speaking, irrelevant. Also there is a hint that your questions are slightly disingenuous in that you have answered them yourself, at least partly. The carry trade is over and has been since July 2007. It was all part of the bubble.

When you talk of bonds, which type do you mean? There are hundreds of different types from government bonds down to risky so called junk bonds. I know that every time poor results for inflation, housing starts and the like are posted there can be a positive effect on the US dollar because of the flight from equities and other investments into government bonds. This is, to me, a new effect and by no means reliable. I don't trade the news in particular, anyway and most successful traders, like me, trade off trends and technical patterns, not fundamentals. Fundamentals give us our charts and patterns but there are too many variables to trade off them alone, with a few exceptions.

For me an exception would be AUD/USD where we have 3 or more fundamental effects in simplistic terms: 1. The US dollar is weak, causing an increase in the price of gold. Australia produces gold. 2. Australia has increased interest rates which gives us currency traders "swap" interest when we long this pair. 3. Australia has a "commodity" currency and supplies Asia with the minerals required for manufacturing. These three main fundamentals have an effect a bit like the carry trade but it is not the carry trade by definition.

If you are an aspiring currency trader I would advise you to learn the basics and add your knowledge of bond trading when it becomes appropriate, if ever.

Thanks for that answer, much appreciated.

Yes, you are correct - I have tried to lay out what my understanding of these issues are at this point. I am trying to understand the basic mechanisms behind the carry trade, simply because I would like to have that knowledge. Once that is obtained, we can probably agree that much of it isn't immediately relevent - but then again: we do take fundamentals into account - and if we do, when trading, isn't it better to understand "too much" rather than too little? Sometimes economic data needs to be interpreted in one way, which might not be how it was interpreted one year ago (an example could be the MPS - in "normal" times a surprise rate hike means a stronger currency, but this spring at times a larger than expected CUT caused the GBP to strenghten - because it was seen as stimulus to the economy.

That's why I'm grabbling with these concepts. Would love to understand better how the stock & bond markets (and other assets that cause capitalflows) interact with and impact currency prices.

Maybe the right question to ask is: does anybody know of any good resourses on the subject?

Thanks!