Category — Carry Trading

Financial markets look to be rebounding after their huge drops in the last couple of weeks. Markets have seen an uptick in value and, and recent news only seems to support that trend. The primary effects of this movement on the foreign exchange market have been twofold: providing the Fed with justification to slow down the easing process and giving Mrs. Watananbe the ability to resume the carry trade.

Let’s look first at how the financial markets have returned to a relative state of calm. The four biggest US banks borrowed $500 million each from the Fed’s discount window yesterday. None of the four actually need the money, but the act is a symbol of trust in and acceptance of the Fed’s recent decision to lower the discount rate. Bank of America also took a new $2 billion stake in Countrywide Financial, the nation’s biggest lender of home loans, a catalyst that drove down corporate bond risk and drove up stocks. Once thought to be on the verge of bankruptcy, Countrywide appears to have survived the crisis, signaling hope for the larger economy. Looking at the broader equities market, the VIX index feel even more yesterday, now sitting more than 40% lower than the highs hit last week.

All this good news might indicate that the Fed doesn’t have to ease rates to the extent that futures traders have priced in. And indications from US central bankers point to the Fed not really wanting to lower rates just now (the moral hazard problem). The Fed has a number of different options as to what it could do in September and October, but it has to realize that the credit problems are still far from over. Commercial paper is still being ignored to a ridiculous degree, and if a wide scale easing program is not implemented, then we could see the problems of Wall Street spread to Main Street.

A spread to the wider economy is not out of the realm of possibility. Layoffs in mortgage companies are coming, and the big banks are already shutting down their subprime units. More troubling is what happens to mortgage rates if the Fed keeps rates steady. Adjustable rate mortgages are set to be re-priced next month, and with credit conditions as they are now, we will see consumers swamped with enormous debt service bills. Consumers are the engine of the US economy, and any slowdown in that sector because of higher bills could be disastrous. That said, if the Fed keeps rates steady, it would also be bullish for the US dollar in the short-term. As corporate profits shrink and equities markets decline, we would see a strengthening of the dollar’s safe-have bid, and USD/JPY, especially, would see the bottom fall out.

But with the stock market reasonably strong and most market participants sure of a Fed funds interest rate cut, the US dollar is seeing some capital outflow and so is the Japanese yen. The dollar-yen hit 117 last night, and the carry trade seems to be returning. Mrs. Watanabe saw in the recent drops the same buying opportunity that hedge funds proclaimed (and quantitative funds have made back most of their losses this week). We should see at least two rate cuts this year in the United States and that should generally prove bullish for the carry trade. But as always, be careful.

The yen crosses are all taking a beating. After more than a year of weakness (mostly through carry trade borrowing) the Japanese yen is cleaning up. Even the US dollar, up against all the other major currencies, is not safe from the yen’s resurgence.

The yen is now at its highest level since July 2006. The high-yielding currencies have suffered the most, with NZD/JPY and AUD/JPY both falling over 5% yesterday. EUR/JPY has acted the proxy for carry trade sentiment in the foreign exchange market, and the currency pair fell 2.3%. And just as we predicted yesterday, USD/JPY blew past the stops at 116.50, and reached 113.60 in early New York trading. Even against the pound, which looks to be the most fundamentally-backed of the major currencies has fallen against the yen, as GBP/JPY dropped 700 pips yesterday. The carry trade unwind is on, folks, and this is just the beginning. If the market has its way, the Japanese yen will appreciate even more.

But that’s just the thing. There’s a chance the foreign exchange market will not be allowed to have its way. The Bank of Japan has a well-deserved reputation for aggressive intervention, and it will be looking at the recent yen gains with some dismay. Japan’s domestic economy basically sucks, and the country’s production is being kept afloat by its world-beating export industry. A stronger yen is bad for business. That’s the reason that Toyota’s share price fell 3% last night. The BoJ could look at the yen crosses and say the Japanese currency is overbought. If that happens, we will see the yen give back a lot of its gains.

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.

The carry trade is not back. At all. Stay away for right now. The Dow rallied to close 150 points higher yesterday, and yen crosses followed that stock market rally. The high-yielding currencies, especially, made back a lot of their losses. But the upward movement is likely to be temporary because the current market is not conducive to the carry trade.

Volatility is still significant (the stock market may have ended in positive territory, but it wavered back and forth throughout the day). Risk aversion in the market is at a high level. This is the reason that US Treasuries continue to do well; the bonds gained 1.6% last month, second-best performance of all major international government bonds. And then there are the comments yesterday out of China threatening to dump dollars in response to protectionist legislation in the United States. No rational observer of the market actually thinks this is a likely possibility, but the chance is there. If nothing else, the proclamation by the government researcher reminded investors (in the forex market and elsewhere) of the potential power that China holds to disrupt international financial markets. And the fact remains that we do not have a long-term record to rely on of responsible financial administration out of China. The more people are afraid of risk, the worse the carry trade does.

The carry trade is a complicated proposition for anyone participating in the FX market. That’s why so many people get it wrong all the time, including those who make their living trading the currency. There’s so much information bouncing around the market, and traders are relying on fundamentals and technical analysis and have trouble deciding when different signals suggest different actions. As sacrilegious as it might sound, traders might actually be relying on too much information.

The great thing about the internet is it brings real-time news about everything right to our fingertips. But too many choices (for a trader) can actually be a bad thing. There’s a book out right now called The Paradox of Choice, and it’s about how, at a certain point, more options actually reduce the amount of choices available for an individual. We are paralyzed by the sheer number of things that we look at, and so we are unable to focus (or choose) the most valuable information. Bringing it back to the carry trade, the important observation to keep in mind is the following: carry trade thrive on three market conditions: (1) low volatility in international financial markets, (2) cheap money (or credit) and (3) a strong risk appetite among investors. The carry trade will not rebound because none of those three conditions are met in the current market climate.

The FX trading last night is evidence of this point. EUR/JPY, which has acted as a proxy for carry trade popularity, lost 200 points. The Swiss franc gained support through both a run away from the carry trade and a run toward safe havens. The high yielding currencies will continue to lose ground as both phenomena continue. USD/JPY will be the one of the few yen crosses to buck the trend because of the US dollar’s status as a store of value and a safe haven. But that is an abnormality and should not fool traders into thinking the carry trade is back.

The state of the US economy is not dire, but it certainly does not bode well for the US dollar.  Job creation was at its lowest level since February, with the NFP printing at an abysmal 92K.  But even worse for the dollar is the fact that job numbers are not the cause of growth or decline in the economy.  Payrolls are a reflection of demand; as house prices depreciate and take personal income down with them, that creates less of an incentive for businesses to grow.  In recessionary times, businesses are always slow to cut jobs, as the fall in labor always lags behind the fall in production.  The chance of a US recession will lead the greenback to fall against all the other major currencies.

As of right now, however, the idea of a recession is a little overstated.  But even if the economy is only stumbling (and will pick up later in the year), the US dollar is still going to take a hit.  That is because in this current market, equities are on line to fall even further.  US stocks have already been underperforming for years now compared to foreign equities markets.  And with fixed income in the United States more and more attractive because of the rising risk aversion among traders, that phenomenon is only going to continue.

Even the Fed policy meeting on Thursday is not likely to improve the mood of traders or dollar bulls.  That interest rates will stay the same is a market consensus, and Bernanke seems less inclined than his predecessor to act as a stock market savior.  The “Greenspan Put” should be pronounced dead, and forex observers can expect the announcement on Thursday to remain hawkish on inflation.  The futures market is pricing in a 100% chance of an interest rate cut in early 2008, but I believe the Fed funds rate will remain at 5.25% through the end of 2008.

The problems in the US housing market are a concern, however.  American Home Mortgage declared bankruptcy this morning, becoming the second-biggest lender to do so amid the subprime fallout.  Bear Sterns continues to take hits, with S&P announcing a negative on its debt rating.  The primary beneficiary of the weakness in US assets is the euro.  Ever since its inception, the euro has acted as the anti-dollar, providing an alternative for currency traders soured on the US market.  That is certainly the case right now, as euro bulls are having a field day.  Look for EURUSD to test 1.3900, and if it can overcome the resistance there, then the pair should see clear sailing through 1.4000.

After the euro, the other major currency to benefit in this forex climate is the Swiss franc.  Look for the Swissie to be the biggest gainer against the US dollar this week.  The low-yielding currency has found support as the carry trade has unwound.  As painful as carry trade unwind has been for those shorting the franc, history tells us that we are not even close to done yet.  The franc already hit a two-year high against the US dollar early this morning, with USDCHF reaching 1.1868.  The Swiss franc is both a growth story and a safe haven in a time of risk aversion, making it extremely attractive to currency investors.

We’ve been talking about the carry trade unwind for the past couple of days.  The moves in the forex market yesterday and during Asian trading last night ran counter to that assumption.  There was a reversal upwards in the yen crosses, especially CADJPY, AUDJPY and NZDJPY.  The late rebound in the Dow also buoyed USDJPY, as that currency pair has assiduously followed the ups and downs in the equities markets for some time now.  But I am here to tell you that the prognosis with regards to the currencies in the United States and Japan is still yen-positive and dollar-negative.

Let’s starts with the bad news for the US dollar.  The bond market is pricing in a 100% chance of an interest rate cut in January.  DailyFX.com has a fascinating take on the interest rate speculation through a look at the comments of various US monetary policy makers, with the ultimate scenario suggesting a more dovish outlook for the Fed.  The ADP survey shows terrible job growth numbers, coming in at only 75K.  Earnings for most US corporations continue to be relatively stellar, but the money refuses to trickle down, and dollar bulls may have to come to terms with a slowdown in US expansion.

Coming to the yen, most currency analysts see still more room for the room to grow.  The Chicago Board Options Exchanges’ market volatility index (VIX) hit a yearly high yesterday, and greater volatility is a death knell for the carry trade.  Kathy Lien of FXCM posts a two-year chart of USDJPY that will not provide comfort for yen bears.  The interesting thing about the chart is not that it necessarily signals a move downward in the currency pair but that it demonstrates the potential of a possible drop.  And that drop would be disastrous for those still long on the carry trade.

For some months now, dips in the yen crosses have not really been something to worry about; rather, these dips have been seen by Japanese retail investors as opportunities to short the yen.  There has been talk all over the market about “Japanese housewives” beating the pros and serving to stabilize the market by keeping carry trades alive.  But a recent Bloomberg report claims that the risk appetite for Japanese traders is dropping.  They are wary of selling the yen now because they anticipate still more appreciation for the currency, which has the potential to be a self-fulfilling prophecy.  And contributing to the growth of the Japanese yen are the losses all over the hedge fund market in the United States.  The hedge funds were some of the primary drivers of the carry trade, and their exits from the forex market (at least in this limited capacity) might serve notice to the rest of the market that the carry trade is, indeed, unwinding.

A worldwide credit crunch and economic problems (mainly in the United States) have torched the equities markets for the past two weeks.  There are fears that the subprime mortgage crisis and the housing problems will escape their respective sectors and infect the market as a whole.  The losses are magnified by the uncertainty of many traders, exemplified by the VIX volatility index surging past previous levels.  As is usually the case in a situation like this, risk aversion is controlling the market.  With regard to foreign exchange trading, two phenomena emerge: a flight to safety for capital and a carry trade unwind.  As Boris Schlossberg of DailyFX.com notes, the only winners in this scenario are the US dollar and the Japanese yen.

Flight to safety in the forex markets is beneficial to the US dollar, at least temporarily.  This is because investors pare back from riskier investments and park their capital in dollars for the time being.  The result is a peculiar situation where the crumbling of US markets is actually a boon for the US dollar.  But traders should realize the dollar strength will not last.  As for the US stock market, there is a sense that the credit crisis is reaching other areas; there are reports in Bloomberg that situation with subprime mortgages are hurting the earnings of companies across the spectrum.

And the economic reports have been mixed.  The regional manufacturing surveys (Philly Fed and Chicago PMI) have disappointed, confounding observers who thought the weak dollar would allow exports to support the manufacturing sector.  But unemployment is in line to grow by 100K for the NFP report later this week.  How traders react to that data will determine the long-term direction of both the US economy and the US dollar, but on a short-term basis, the dollar looks good.

Growing risk aversion also creates problems for carry trade longs.  Yen bulls have killed the fx market for the last two weeks.  There has been a 1000 pip decline in GBPJPY (from its record high), and the yen has also gained 700 points against the three commodity currencies.  In fact, the yen improved against all 16 most highly traded currencies last night.  Carry trade lovers cannot start crying over their losses yet, however; Kathy Lien of FXCM claims there is still plenty of room for the yen to appreciate.  Fear is the dominant factor ruling the currency market right now, signaling a strong near-term weakness in the Australian dollar and the New Zealand dollar, two currencies that have gone up significantly on the back of the yen-based carry trade.  I am not one who believes that the credit crunch puts us in line for a global slowdown (and the great thing about trading currency is that it doesn’t matter—there is the same opportunity for profit in a bear market as there is in a bull market).  But I think traders should be wary of high risk investments and focus instead on more stable currencies and economies.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

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.  

Yen carry trades have dominated the forex market for the past couple of months.  With international equities markets booming and high yields to be found in other countries, traders have been borrowing the yen on the cheap to finance their investments.  That has brought the yen to multi-decade lows against all the highly traded currencies.  But yen crosses look to be in line for a corrective decline.

The engine for carry trade demand has been the search for higher yields elsewhere in the world.  And the relative ease with which those yields could be found encouraged currency traders.  However, global equities are falling and credit spreads are beginning to widen.  Forex investors are seeing these developments and reacting with worry.  They are paring risk and liquidating their carry trade positioning.  As evidence of this situation, USD/JPY touched 119.12 per dollar in New York trading this morning, its lowest level since May 1.  EUR/JPY has regressed as well, falling to as low as 163.88 per euro.

The other factor contributing to the carry trade unwind is the possibility that shorting the yen will cease to be a one way bet.  There is growing speculation that Japan may intervene in the fx market to prop up its currency, and it certainly has the foreign reserves to do some damage.  Bank of Japan board member Tadao Noda spoke yesterday about the risks associated with a weak currency.  Hiroki Tsuda of the Finance Ministry warned the market that currencies should reflect economic fundamental and that the government would be watching the forex market for irregularities. The impact of both of these statements is that, if believed, they could serve to lower capital outflows from Japan.

There are fundamental signs that the Japanese economy is ready for an appreciation of its currency.  Consumer spending seems to be recovering, with CSPI printing at a year-over-year growth of 0.6%, a 10-year high.  Household spending has been in positive territory since the beginning of this year, suggesting that price action is likely to drive yen crosses even lower.  Forex professionals have been predicting movement in the yen to 115 for months now, and there have been reports in Bloomberg about Japanese housewives keeping the carry trade afloat.  It has been very tempting to be short the Japanese yen in recent times; you can earn the carried interest without threat of a swing back in favor of the yen.  And while you may have made a good deal of money this way, it might be time to look elsewhere for your investments.  One of the worst moves a forex trader can make is to fall in love with his own trades, and the time is now to unwind the carry trade and find some other vehicle for growth.