Dow Rebounds: What Does It Mean for the Carry Trade?

The US stock market rebounded from recent lows yesterday.  The Dow rose 187 points, and that has a significant effect on the international currency market.  This is especially true with regard to the carry trade, specifically, with regard to the Japanese yen-based carry trade.  Through the years, technical analysis comparing the forex market with the equities market has shown a long-term positive correlation between the carry trade and the stock market (more on the relationship between the carry trade and the Dow). 

            The stock market rose on the back of this month’s Beige Book Report, which was slightly more optimistic than last month’s report.  The relatively decent condition in all the Fed districts gave many traders a reason to invest.  And as we would expect, carry trades took off yesterday.  The Yen currency crosses rose, with the USD/JPY hitting a four year high and the Australian dollar was up to a 15 year high.  As the Dow continues to rise (and there’s no reason it should stop), this should support the carry trade and drive the Yen lower. 

            But investors should be wary of uninterrupted gains through the carry trade.  Goldman Sachs Groups Inc. has just issued a notice for carry traders, warning of higher volatility upcoming in international markets.  This volatility would not only be evident in the stock market, but in the currency markets as well, proving disastrous for carry traders.  There is a feeling among some forex traders that we are approaching a bottom in volatility.  Of course, for a one-way bet like the carry trade, low volatility is essential for continuing positive returns.  But we might be approaching the mature end of the current growth cycle, and history has proven that traders have had difficulty predicting monetary policy at these times. 

            There are examples of this in recent forex market developments.  Traders in both the US and Canada have been moving back and forth in the futures market on the subject of rate hikes or rate cuts.  Speculation has been rife on future policy changes by central banks in Asia, Europe and the Americas.  A return to high volatility in either equities or foreign exchange could spell the doom for carry traders.  In the end, the carry trade should be a viable strategy for now, but traders should not hope for positive gains forever.