Posts from — June 2007

Carry trades are still a ubiquitous feature of the forex market, but the driving force in the market today is not Japanese interest rates.  The ten-year US bond market has been the largest influence on international currencies.  The bond market has suffered recently, and the high yields have provided crucial support for the US dollar.  Especially with little US economic data on the docket for this week, currency traders are increasingly relying on yields to make their bets.

Yesterday, the US dollar gained ground against the Japanese yen, the euro and the Canadian dollar while losing ground against the New Zealand dollar, British pound and the Swiss franc.  The most interesting part of that scenario is that, with the exception of the Swiss franc, the dollar gained against every currency over which it had a yield advantage and lost against the currencies that had a yield advantage over it.  What we should ask ourselves is why US bond prices continue to fall?  Unfortunately, there is not a clear cut answer to that question.  But it might have something to do with the sub prime mortgage loan crisis in the United States, typified by the shutdown of two large hedge funds by Bear Sterns.

The effects of this on the currency market are startling.  While carry trades are in play, much of the momentum for the USD/JPY growth is certainly coming from high US yields.  With 10-year bond yields again reaching 5.15%, the forex market is simply shrugging off most other economic news.  Wednesday’s European economic data was actually pretty heartening.  PMI readings, especially in manufacturing, were better than expected, but the euro still fell against the dollar, as US yields determined the action.

The general situation repeated itself this morning.  The Federal Reserve Report for Philadelphia came out, and there were more first-timers on the unemployment rolls.  But the rest of the data was strong, with manufacturing picking up after a long layoff.  But the movement in the currency market was dollar-negative.  The US dollar lost most of its gains versus the Japanese yen and the Euro on the basis of falling bond yields.  The Germany IFO Business Climate Report is scheduled to be released at 4:00 PM today, and the data is likely to be positive.  But if recent forex activity has shown us anything, it’s that what happens to US 10-year bonds will matter more when it comes to currencies.

The most important news today (at least in terms of the foreign exchange market) is the release of the minutes of last month’s BoE Monetary Policy Committee meeting.  The release surprised most of the market with a more hawkish-than-expected stance.  The Committee did vote to keep interest rates steady in June, but the vote was much closer than many traders had predicted.  Most market analysts had expected a 7-2 vote against a rate hike last month, but the actual vote was 5-4.

In addition to that, Governor Mervyn King was one of the four dissenters calling for a rate hike.  The bank’s governor has only been overruled twice in the 10-year history of the Monetary Policy Committee.  Many traders today feel that with King now calling for a rate hike, the decision is almost a done deal.  Today’s release of the meeting’s minutes only confirms forex market speculation that began with hawkish comments earlier in the month by Governor King and others.

There are other important currency market considerations regarding interest rates besides the comments of the Committee members.  Money supply growth has reached its fastest annual pace in seven months.  Oil prices are still at $69/bbl.  Other inflation indicators are also robust, including the British housing market and the index of prices in shops.

It is difficult to predict the actual actions of central banks (that doesn’t stop currency strategists from trying).  But the various exchange markets have already felt the impact of the release of the Committee vote.  Futures market traders are betting on a rise in rates to 5.75% at the next meeting.  In the forex market, the future rate hike is being priced into the value of the pound right now.  For example, GBP/USD easily cleared 1.9900 after today’s minutes release, and it is likely not to encounter much resistance at 2.000.  The pound has also risen against the Japanese yen, climbing to its highest level since 1992.  Look for strong support for pound long bids in the coming day as the forex market prices in the likely BoE rate hike.

The yen carry trade remains strong in the foreign exchange market, but before analyzing why that is the case, let’s look at some specific exchange rates.  The US dollar has fallen in recent trading versus the euro (EUR/USD) and the pound (GBP/USD).  Bond yield in the US have declined from their record highs.  Home builder confidence is at its lowest in sixteen years.  And the CPI numbers last week (with core prices rising only 0.1%) demonstrate the slowing pace of inflation.  Put those factors together, and you get weak support under the dollar.

The pound and the euro, however, continue to receive strong bids in the currency market.  Much of this has to do with a growing consensus among traders concerning the likelihood of a rate hike by both the ECB and the BoE.  President Trichet of the ECB recently came out and said the new emergence of many fast-growing economies around the world is creating a upward pressure on prices.  These hawkish comments were coupled with remarks by other ECB members asserting the ability of other European economies to withstand a future rate hike.

The flipside of this strength is the persistent weakness of the Japanese yen.  There is optimism among Japanese policymakers (after the GDP and Industrial Production data), but the growth is still not robust enough to survive higher interest rates.  This is especially true with regard to the Japanese consumer.  And the low interest rates in Japan prove irresistible to carry traders.

Take the EUR/JPY pair.  It hit an all-time high of 166.12 yesterday eventually settling at 165.91.  The euro-yen has been a one way bet recently, and the tame US inflation reports will keep it that way.  The carry trades are unlikely to be interrupted in the near future considering the low risk of global inflation in the current currency market.  The US inflation data signals lower volatility in international exchange rates in the future.  So traders have more confidence that they can capture the differences in yields in two countries without the risk of losing those gains thorough market swings in the exchange rates.

But there is one important caveat for enthusiastic carry trades.  BoJ governor Fukui has said that it is important for the country to raise real interest rates to help domestic pension plans.  There is also a concern for political repercussions in Europe and the United States if the continuing devaluation of the yen proves to be too much of an advantage to Japanese exporters.  Lastly, 10 year bond yields in Japan have reached 1.935%.  Yield levels of 2.00% or higher could lead to a return to the domestic bond market for Japanese institutional investors.  That by itself could push the Japanese currency up, destroying carry trades.

The defining action this weekend had traders basing their decisions almost entirely on yield differentials between countries.  In many cases, broad economic data was ignored in favor or inflation expectations and interest rates.  That’s why it is so important for foreign exchange traders to study the futures charts and determine which central banks the market thinks are likely to raise interest rates.  Example number one is the state of the US dollar.  Friday’s CPI report drove the market for the dollar.  Core prices rose only 0.1% in May, signaling that inflationary pressures were under control and in line with the growing economy.  As such traders in the forex market see no reason for interest rate hikes in the near future, and the dollar has suffered as a result.

The Japanese yen and the Swiss franc have also fared poorly in the currency market mainly due to interest rates.  The economic situation in Japan and Switzerland is completely different.  The Swiss economy is robust and growing at a rapid pace, while the Japanese economy, despite satisfactory GDP growth, still has to contend with weak consumer demand.  Yet both currencies are experiencing a similar freefall; low interest rates in both Japan and Switzerland make carry trading especially attractive.   The Bank of Japan not only did not raise rates in their meeting last week, but its comments suggested that it was unlikely to raise rates next time either unless consumer demand picked up.  The Japanese economy is simply not ready for interest rate hikes.   In Switzerland, despite much stronger economic data, the SNB chose to only raise rates by 25 basis points.  This did not do nearly enough to cut the rate differential between the franc and the other European currencies.

The situation is only exacerbated by the possibility of interest rate hikes by both the Bank of England and the European Central Bank.  The currency market is loading up on both the pound and the Euro in anticipation of in anticipation of those future rate hikes.  Hawkish comments about inflationary pressures by European Central Bank council members continue to bid up support for the Euro (EUR/USD at highest in two months) despite poor Industrial Production and Retail Sales data.  In England, BoE Governor Mervyn King is as hawkish as ever concerning rising inflation.  The likelihood of rate hikes is being priced into both currencies, leading to gains across the board, especially against the US dollar, Japanese yen and Swiss franc.

The Yen was hammered last night in the forex market.  In the Bank of Japan meeting there was a decision to keep the overnight lending rate at 0.5%, the lowest among all the major currencies.  All the major currencies increased against the Japanese yen as it became obvious that rate differentials were not going to compress.  But as Boris Schlossberg of DailyFX.com points out, the losses probably had as much to do with the bank’s reluctance to commit to a rate hike in August as they had to do with today’s decision.  The policy makers in Japan admitted that they were more worried about the still-lagging domestic consumer demand than they were about the admittedly undervalued currency.

Carry traders continue to rejoice with the non-move in interest rates.  With no danger of a US rate cut, USD/JPY reached a fresh 5-year high.  There is cause for some worry for carry traders in the currency market.  The undervalued yen has led to an advantage for Japanese companies overseas.  There has already been complaining in Europe about this advantage.  If policy makers in the US jump on this bandwagon as well, it could lead the BoJ to institute a preemptive rate hike.

Going back to the dollar, there are a few signs of continuing dollar strength.  On June 14, we saw PPI numbers that positively surprised the forex market.  Almost all recent data that has come out the US has been higher than expected and supported dollar bids.  And in the last week, high bond yields have continued to suggest an interest rate hike by the Fed.

But today’s data shows creeping signs of dollar weakness.  Home mortgage rates last month reached record highs, as did foreclosures.  With that kind of negative push on the US economy, it might be unwise to raise rates at the time.  In addition, today’s CPI report came in surprisingly tame, with a lower-than-expected rise in prices.  Production at factories, mines and utilities declined last month, and consumer expectations have been underwhelming.  A repeat of this kind of performance in coming days might give the Fed some cover for a rate cut.  And it is that fear that allowed EUR/USD to gain so strongly yesterday.

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.