The carry trade is simple in principle: borrow low and lend high. Pay depositors 3% on their savings so you can lend it out for mortgages at 7%. The 4% difference is profit for the banks. Internationally, it is a similar principle, and may explain some of the bizarre relationships now being seen in world currencies.
It goes something like this: If the Japanese central banks sets its lending rate at or close to 1% year after year, and if the European central bank sets it closer to 5%, and the two currencies stay fixed against one another, then wouldn’t it be sensible to borrow from a Japanese bank where loans are going to be cheaper, convert the yen to euros, lend out the euros at the higher interest rate, then when the loan is paid back in euros, convert those euros to yen, and pay back the Japanese bank?
That works, so long as (1) all currencies involved are readily available in a fluid market, and (2) everyone is paying back what they borrow, and (3) currencies are holding their relative value against one another and exchange costs aren't too high.
In a liquidity crisis, say the Japanese banks are holding on to yen because they are facing currency crises of their own, and don’t want to lend to foreign banks out of a general lack of trust in the creditworthiness of the system, then the yen becomes increasing scarce, and begins to skyrocket on foreign exchange markets in a scramble to make repayment obligations.
While Japan has operated in a system of suppressed interest rates for decades, for America this has been true as well for the better part of this decade, and the dollar has become a carry currency. In other words, American banks have lent to foreign banks in dollars, and the foreign banks converted those dollars to, say, euros, and then lent euros out at higher rates to whomever for whatever, and when paid back they converted euros to dollars and paid back U.S. banks. Now as dollars are becoming scarce, it’s value in foreign exchange markets is quickly rising, which may be behind the Federal Reserves recent printing campaign, and its pledge to supply foreign banks with all the dollars they ever need with their own currencies as collateral.
The simultaneous plummeting of most world currencies against the dollar, except the yen which is swinging but mostly rising, suggests we are in the beginning phases of a collapse of an overleveraged international carry system. Details will be commented on further as the process continues.