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Cutting the Gordian Knot of Carry and Imbalances

Countries' external imbalances or interest rates produce similar currency sorts on average. Disentangling the two signals, we find that carry risk premiums come entirely from interest rates. An alternative carry formed on interest rates orthogonal to external imbalances increases the Sharpe ratio by 38% and is not spanned by traditional carry or imbalance factors. Strikingly, this new orthogonal carry subsumes traditional carry. Traditional carry has well-known exposure to stock market returns and performs badly when FX volatility is high. We find these stylized facts are entirely driven by its association with imbalances factors which have similar risk attributes while orthogonal carry does not.