Carry trade in developing and developed countries: A Granger causality analysis with the Toda-Yamamoto approach

This paper explores the relationship between the carry trade and four related financial variables (interest rate differentials, market sentiment, local stock market indices, and the US stock market index) in ten currencies (Australian Dollar, Brazilian Real, Canadian Dollar, Euro, Great British Pound, Japanese Yen, Mexican Peso, New Zealand Dollar, Russian Ruble, and Swiss Franc). By considering both periods of monetary easing and tightening in the US after the 2008 crisis, I estimate Granger causality tests using the Toda and Yamamoto (1995) approach. Additionally, according to the interest rate differentials between these countries and the US, the currencies are classified as target or funding. Results show relevant differences and similarities in the long-term relationship of these variables for each analysed currency and monetary period in the US. Most importantly, regardless the strength of the US dollar (weak or strong), exchange rate is a good predictor of carry trade activity. Results for the period of monetary tightening (stronger US dollar) show that the carry trade Granger causes the market sentiment and local stock market indices. Therefore, a hawkish monetary policy in the US may be a source of systemic risk considering its effects on the carry trade.