When central banks cut interest rates, they do so for a reason. They would like to stimulate economic activity by discouraging saving and encouraging borrowing. They would like consumers to spend more and companies to invest in new projects.

But it is not just the “real” economy that responds to lower interest rates. Cheap money is an important influence on financial markets. It brings out the speculator in everyone.

Relying on the financial markets to make you rich can be a very slow process, if asset prices are rising by only 6 or 7 per cent a year. But if you can invest with borrowed money, the road to wealth becomes that much shorter.

The best news of all comes when you can make money in two ways. First, of course, the assets you buy can rise in price. But second, the asset you buy can offer a higher income, or yield, than your borrowing cost. Even if prices go nowhere, you are still ahead.

This simple trick is known as the “carry trade”. The income from “carrying” your asset is positive. And when interest rates are as low as 1 per cent, as they were in the US until the summer of 2004, there are lots of other assets with higher yields available.

The simplest carry trade of all is to borrow money in your own currency and invest in your local government bonds. No currency risk is involved; the only risk is that the bonds fall in value.

But for much of 2003 and 2004, US investors could earn an extra kicker from the carry trade. The dollar was falling. So they could borrow at low rates in dollars and invest in overseas assets. If all went well, they could earn money three ways: the asset would offer a higher yield, it would rise in price, and the dollar would fall, bringing a currency gain.

The carry trade could be used to finance purchases of European government bonds, emerging market shares and even commodities.

How large is the carry trade? The best evidence may come from the pattern of market movements. In early 2004, many investors were convinced that it would be a long time before the Fed raised rates again; that made the carry trade look very attractive. But in the spring, a rash of positive economic data made a Fed move look more likely.

What markets then saw was weakness across a range of financial assets, from equities through bonds to commodities and emerging markets. About the only thing to gain ground in April and May last year was the dollar. The obvious interpretation was that speculators were cutting their carry trades, reducing their dollar borrowings (thus forcing the currency higher) and selling the assets they had acquired.

But the trade did not disappear altogether. Even after eight rate increases by the Federal Reserve, US short rates at 3 per cent are pretty low by historical standards. They are even lower, at 2 per cent, in the eurozone, and they are virtually zero in Japan.

This year has seen a different variant on the trade. Borrowing to buy Treasury bonds was not popular since government bond yields were expected to rise sharply (equating to a fall in prices). Furthermore, the gap between short rates and bond yields has narrowed, making the carry less positive.

Instead investors seem to have chased higher risks, borrowing to buy corporate bonds which offer a higher yield and thus a better carry. This bet too seems to have gone wrong. The downgrade of General Motors and Ford has caused higher-yielding bonds to fall. The dollar has risen, punishing US investors who made bets on overseas assets. And Treasury bond prices have risen, hurting investors who attempted a variant on the carry trade; being short Treasuries while long corporate bonds.

It is no surprise, therefore, that hedge funds have suffered another difficult time in recent months. According to the French business school, Edhec, short-sellers were the only category of hedge fund to make money in April; managed futures funds, which attempt to exploit market trends, have lost 7.8 per cent so far this year.

Hedge fund losses need to be taken into context. If you take the average fund of funds as representative of the sector (and this is a bit unfair because of the effect of two layers of charges), the industry has lost 0.4 per cent so far in 2005; equity investors often lose more than that in a single day.

Of course, individual hedge funds will have suffered a lot more than that; the dollar programme of the John W Henry managed futures fund is down 40 per cent in the year to date. As yet, there are no signs of the equivalent of the Long-Term Capital Management collapse that traumatised financial markets in 1998.

But there is still the potential for long-term danger from the ending of the carry trade. The problem with LTCM’s collapse was the threat it posed to the stability of the banking system; the fund had borrowed massively from the leading banks.

Banks appear to have become more cautious about lending to hedge funds since then. This time the risks may come from another direction. The trading desks of investment banks operate in a similar fashion to hedge funds (indeed, many hedge funds are set up by former bank traders).

They too have been indulging in the carry trade. If investment banks and hedge funds attempt to exit from the same positions at the same time, they could drive down prices sharply. In some of the more obscure asset classes, such as the riskier tranches of collateralised debt obligations or CDOs, banks and hedge funds may constitute nearly all the active participants. There may thus be no-one to sell to.

Banks have, of course, sophisticated trading models which they use to monitor these risks. But will they work when applied to new instruments at times of market turmoil? And will they force banks to cut their riskier positions at the same time, exacerbating price falls?

Furthermore, it is arguable that the last two decades have been ideal for the banks; falling interest rates and rising asset prices have made the carry trade profitable for much of the time. If the banks now face rising rates and stagnant or falling asset prices, will their profits collapse? With financial profits comprising some 35 per cent of US domestic profits, that is a significant question for the entire stock market.