A Momentum-Based Carry Trade blends two powerful systematic strategies: carry (profiting from interest rate differentials between currencies) and momentum (capturing trending price behaviour). This hybrid model improves the timing, selection, and risk-adjusted returns of traditional carry trades by only allocating capital to currencies that offer positive carry and strong price momentum.

This article explores how a Momentum-Based Carry Trade strategy is structured, the advantages over static carry trades, and how institutional traders apply it in FX and cross-asset macro portfolios.

Why Combine Momentum and Carry?

• Carry trades perform poorly in volatile, range-bound markets.
• Momentum filters help avoid “value traps” where high yield is offset by falling prices.
• Improved entry/exit timing based on price action.
• Empirical studies show the carry + momentum combination consistently outperforms standalone carry.

By combining yield with trend-following behaviour, traders align themselves with both economic and behavioural alpha.

Core Components of a Momentum-Based Carry Trade Strategy

1. Currency Selection via Interest Rate Differentials

• Rank G10 or EM currencies by short-term interest rate differentials (e.g. 1M or 3M swap rates).
• Select top 3–5 high yielders and bottom 3–5 low yielders.
• Define the carry spread: Long high yielders, short low yielders.

Example:
Long MXN and ZAR, short CHF and JPY in a positive carry basket.

2. Momentum Filter Overlay

• Apply trend filters to eliminate weak or reversing trades:
  • Price momentum: 1M, 3M, or 6M returns.
  • Moving average crossover: Spot above 50- or 100-day average.
  • Relative strength: Long currencies with strong recent performance.

Strategy rule:
Only include long carry currencies with positive 3-month momentum. Remove if trend turns negative.

Example:
Exclude TRY from the long carry basket if USD/TRY is rising sharply (i.e., TRY is weakening despite positive rates).

3. Position Sizing Based on Carry and Momentum Scores

• Weight currencies by a combined carry score and momentum score.
• Assign larger weights to currencies with both high carry and strong trend strength.
• Reduce or remove allocations to currencies with carry but negative momentum.

Quantitative approach:
Normalise both carry and momentum into z-scores, then combine into a final score for ranking and allocation.

4. Dynamic Rebalancing Framework

• Rebalance weekly or monthly based on updated rankings and price signals.
• Use tighter filters or thresholds during high-volatility periods (e.g., VIX > 20).
• Apply volatility-adjusted sizing to prevent overexposure to high-beta currencies.

Tactical insight:
During global risk-off, reduce EM carry exposure regardless of momentum signals to manage drawdown risks.

5. Risk Management and Hedging

• Limit exposure to any single region (e.g., LATAM, Asia).
• Include tail-risk hedges like long JPY calls or USD puts.
• Monitor cross-asset volatility (VIX, MOVE, CVIX) to scale risk dynamically.
• Stop-loss or exit if:
  • Momentum reverses sharply.
  • Spot deviates more than 2 standard deviations from trend line.

Example Portfolio Setup: Momentum-Based Carry

Macro environment:

• Global growth stable.
• FX volatility low.
• Monetary policy divergence (e.g., Fed hawkish, ECB dovish).

Positioning:

• Long basket: MXN, INR, and NOK (positive carry + upward momentum).
• Short basket: JPY and EUR (low yield + negative price action).
• Neutral/hedged: TRY excluded due to recent selloff despite high yield.
• Allocation favours MXN over INR based on stronger relative price trend.

Key Risks and Mitigation Techniques

Risk	Mitigation
Trend reversals	Use momentum stops and confirmation rules
High carry but weak price action	Filter using momentum criteria
Volatility spikes	Scale down position sizes, use options for tail protection
EM FX illiquidity or devaluation	Limit EM weighting and use NDFs or options to manage exposure

Advantages of Momentum-Based Carry Strategies

• Superior performance in trending macro environments.
• Avoids static carry pitfalls during regime shifts.
• Systematic and scalable across FX, rates, and even commodities.
• Improves Sharpe and reduces drawdowns compared to classic carry models.

Conclusion

Momentum-Based Carry Trade strategies offer a smart evolution of the traditional yield-seeking approach by layering in market behaviour signals. By only trading carry pairs that are trending in your favour, you increase the probability of success, reduce drawdown risk, and align with both macroeconomic fundamentals and market sentiment.

To learn how to build systematic FX carry models, apply momentum filters, and construct macro-validated trend portfolios, enrol in our expert-led Trading Courses designed for currency strategists, macro traders, and systematic portfolio managers.