Before the subprime horror show began this summer, it was currency carry trades that frightened investors. A rapid unwinding of positions by those borrowing in currencies with low interest rates in order to invest in higher-yielding ones was expected to bring chaos to foreign exchange markets. As ever, the real shock came from elsewhere. But carry trades became, temporarily, a barometer for investors’ risk appetite. From July to October, there was a weirdly high correlation between equities and popular carry trades, such as the Australian dollar against the yen. On days when the S&P 500 index fell, Japan’s currency rose, and vice versa.

Over the last fortnight, that odd correlation with equities has broken down. Now when stock markets plunge, there is no automatic drop in the New Zealand or Canadian dollars. Instead the fundamental factors behind carry trades have come to the fore again. Investors are paying attention to Japan’s economy; recent bad news suggests that interest rates are staying low. Inflation, however, is picking up in other countries. This explains why the yen has not bounced as much as feared. It is also why, in spite of tricky equity and credit markets, a smaller than expected number of carry positions have been unwound, futures markets and government data suggest.

In addition, another fundamental influence on currency markets, commodities, seems to be reasserting itself. High prices have supported the Canadian and Australian dollars in spite of the latest bout of equity market selling. Lehman Brothers have researched the link between a country’s trade-weighted exchange rate and the relative change in prices of its imports and exports (its terms of trade). Its conclusion is that much of the behaviour of carry trades over the last five years can be explained by the rally in commodity prices. So, it will probably take more than just higher-risk premiums to shake investors out of their positions. If the resources boom ends, however, the resultant unwinding of carry trades could be genuinely scary.