The Carry Trade is Screwing up My Graph

The carry trade has been screwing up the graphs of many international trade and finance economists, so The Economist took the time to explain why. Here's the gist of the article:

The carry trade describes the speculative investment strategies of currency traders that are making money by borrowing Japanese Yen at interest rates of around 1 percent, and then converting Yen to Dollar assets offering a higher rate. When the dollar denominated assets reach maturity, traders convert the dollars back to Yen at a profit.

According to the theory of uncovered interest parity, the only way one currency can offer a higher real interest rate than another is if the high rate currency is expected to lose value (depreciate) against the low rate currency over the time horizon of the investment, thereby eroding the gains from the interest rate differential. So, if dollar assets bear higher interest rates than Yen assets, we would expect---or the theory would predict---that the dollar will lose value relative to the Yen so that when the trader converts his/her dollars back to yen, all of the profit from the interest rate differential is lost.

In the carry trade, not only are traders making money, which they shouldn't, but the dollar is appreciating against the Yen.

One possibility is that "the actions of carry traders are self-fulfilling; when they borrow yen and buy the dollar, they drive the former down and the latter up."