When Do Commodity Prices Matter for the Carry Trade? The Role of FX Liquidity

Abstract

Carry traders invest in high-yield currencies, which are typically the currencies of commodity exporters. Guided by this stylized fact, we study the impact of commodity prices on carry trade performance. Commodity price shocks contemporaneously explain and predict carry trade returns but only when currency market liquidity is low. Our findings are consistent with the premise that a decline in commodity prices is perceived as negative news for commodity exporters and induces carry traders to unwind their positions, thereby exacerbating the downward price pressure during liquidity dry-outs. This sheds new light on the interconnection between the commodity and currency markets.

Keywords: Carry Trade, Commodity Prices, FX Liquidity, Exchange Rates

JEL Classification: C32, F31, G15