Carry Trades Unwind on Risk-Aversion

Yesterday’s report on the extremely sluggish U.S. housing market sent equities markets crashing, investors dumping corporate debt, and currency traders unwinding carry trades. New U.S. homes sales for June fell 6.6 percent. This number has jumped significantly from the 2.2 percent decrease in May. According to a Bloomberg article, this may be a no end to the real-estate slump. The housing issue has even breached the international level as a report today by the U.K.’s Nationwide Building Society showed home values to have risen only 0.1 percent in June, the slowest in 15 months.

The faltering confidence in the equities markets has also brought shifts in forex. Despite having been on a six-week run against the dollar, the pound took its biggest fall in the last five months. The pound dropped 1.0 percent in one day to $2.0305 at 1:04 p.m. in London from $2.0491 late yesterday. On July 24^th the pound had reached $2.0654, its highest level since May 1981. The pound and the euro also took major hits against the yen, indicating investors are losing confidence in their carry trades with the Japanese currency. Against the yen, the pound fell to 241.27 from yesterday’s close of 243.21. Steven Barrow, chief currency strategist at Bear Stearns Intl. Ltd. in London, states: “There’s a reasonable degree of panic going on with the whole mortgage and credit issue and that has encouraged risk aversion.”

Currency Outlook and Strategy:

The sharp fall in the pound has allowed the 14-day RSI for the GBP/USD to fall below 70. This indicates that a reversal will not come anytime soon. Kathy Lien, chief currency strategist at FXCM expects “room for more losses” in the pound. In addition, traders have taken steps to hedge against the risk of a rallying yen. The cost of options protecting against gains in the yen rose to a 3 year high. This movement of risk aversion indicates a revival in the carry trade may not happen anytime soon. Neil Jones, head of European hedge fund sales at Mizuho Financial Group Inc. in London, states: “Investors are looking for some short-term protection on their exposure to the yen strengthening.”

History has shown us an interesting pattern where the EUR/JPY pair has followed a very similar trend to that of the U.S. Dow Jones Industrial. As the Dow takes hits so does the EUR/JPY. See more on this pattern in an article by FXCM technical currency strategist Jamie Saettele. Overall, the leveraged-buyout financing era has taken a huge fall. There is much uncertainty as investors are shifting their portfolios toward less risky assets. Steve Pearson, chief currency strategist at HBOS Treasury Service PLC in London, reflects: “[The] three year period where financial market volatility has declined to low levels is over.” For now it is best to let the markets react and then change strategy.