Category — Carry Trading

Commodity currencies have been beating up on the US dollar and the Japanese yen recently and yesterday was no different.  The Canadian dollar, the New Zealand dollar and the Australian dollar all hit new highs, an occurrence so common in that last couple of weeks that’s most traders simply yawned.  Some of the underlying support for these currencies comes from high commodity prices, especially oil and gold, of course.  But much of the gains should also be attributed to weakness in the US dollar and the yen carry trade.

It is pretty easy to spot the strength the commodity currencies have derived from greenback bears.  The data released in the respective countries has not been really great.  Canada’s inflation numbers yesterday printed lower than expected.  Australia and New Zealand have not released much data recently, and what has been released has been worse than expected.   But the rise of the Loonie, Aussie and Kiwi cannot be stopped.  And that can be traced back to the sluggishness of the US dollar.  And the market consensus after Fed Chairman Bernanke’s speech is that US interest rates are likely to stay the same for some time.  Bernanke also seemed more concerned about the slumping housing market than he has been in earlier speeches.  And so the commodity currencies should continue to benefit from the weak dollar.

The other factor fueling the fresh highs in this area of the forex market is the yen-based carry trade.  The interest rate advantage for Australia and New Zealand compared to Japan is enormous, and currency traders just cannot seem to get away from the high yields.  And that differential is likely to get higher as the futures market lists a 66% probability that the Reserve Bank of New Zealand will raise the country’s interest rates, already the highest in the industrialized world, at its next meeting.  Most currency analysts are pricing in another rate hike this year for the Royal Bank of Australia as well.

The appetite for risk (as well as the hunger for yield) in the market is tremendous, and the surging carry trade is reflective of that.  AUD/USD is at an 18-year high and NZD/USD is at its highest level since the currency was floated in 1985.  While the amazing rate of appreciation might be hurting the country’s exporters, the situation is only exacerbated by the weak greenback.  It is because of this phenomenon that the Canadian dollar is up 12% already this year, with the USD/CAD hitting 1.0416 this morning, its highest level since 1977.  But the latter pressure is not likely to go away anytime soon as many analysts are touting the weak US dollar as good for the American economy.

Two words have dominated the forex market recently: carry trades.  Much of the dynamic price action in foreign exchange has been influenced by the drive for yield best demonstrated by the carry trade.  Currency traders have made a killing borrowing Japanese yen and Swiss francs and using that money to fund high-yielding purchases in Australia and New Zealand.  But the story is about the changing nature of the international carry trade.

The big worry previously was that the problems with the US economy would spread internationally.  The slowdown in consumer spending and the subprime mortgage crisis would trigger a bout of risk aversion, spelling doom for the carry trade.  But the data released today shows those worries to be unfounded.  The US stock market has never been stronger, with the Dow hitting 14,000 this morning.  And foreign investment into US assets reached record highs, climbing $126.1 billion in May.  Japanese investors alone, already the largest foreign holders of US Treasuries, increased their holdings by $400 million, bringing their total to $615.2 billion.  The explosion in American investment certainly accounted for a lot of yesterday’s gains in USD/JPY, suggesting that the forex market’s appetite for risk is still alive and kicking.

The real danger to the carry trade lies elsewhere.  The Swiss franc has been the funding vehicle for those traders scared off by the relative instability of the Japanese economy.  This makes the franc’s recent rally disconcerting to those carry traders.  All elements are in place for a consistent appreciation: a strong economy, a consistent rise in prices and a near certainty of multiple interest rate increases by the central bank this year.  So it should be no surprise to those paying attention that the franc-based carry trade is beginning to unwind with USD/CHF hitting a seven month low.

There are also significant concerns regarding the yen-based carry trade.  A lot of the cheap yen has been used to buy New Zealand dollars, the latter being attractive by virtue of Zealand’s 8.00% interest rate.  This has fueled post-float highs in the New Zealand dollar with regard to both the yen and greenback.  But the New Zealand finance minister came out last night and said that the high domestic currency was causing undue pain for the country’s exporters.  Lacking significant foreign exchange resources, there is really not much the country can do, but the comments should still place a brake on some carry trading.

Japan might also prove discouraging to carry traders.  The odds are relatively high that the Bank of Japan will raise rates at its next meeting in August.  There is also an incredible amount of pressure from the United States and Europe about the unfair advantage that the undervalued yen gives to Japanese exporters.  And Japan actually has the resources to intervene in the forex markets and make it stick.  It is for that reason that some Asian traders, fond of the carry trade, are now using the Singapore dollar and the Chinese yuan as their funding currency.  I would not recommend this course of action, however, as the market for the latter two currencies is too illiquid.

So what should the average currency investor do about this situation?  You are probably okay sticking with the Japanese yen for right now.  The major yen crosses, especially the pound and the dollar should continue to gain.  It is true that the yen losses are overextended; the depreciation is not entirely supported by fundamentals.  But the market’s appetite for risk and hunger for yield should trump all other concerns for right now.

The problems with sub prime mortgages might not be as contained as some observers have tried to claim.  The S&P announced yesterday that they may cut the credit ratings on $12 billion worth of bonds backed by sub prime mortgages.  And it is increasingly likely that if this decision is made, it will force a reevaluation of all similar assets in the US market.  Rather than have the crisis confined to a particular sector, the mortgage situation reveals a poor and rotting basis for the entire economy.

This is bad news for the US dollar.  The sub prime fiasco will spill over into the overall market for US securities and bonds.  With US dollar-denominated assets less attractive, demand for the US dollar in the forex market goes down.  The domino effect does not end there, however.  The US market is the most important one globally, and problems there will trigger another bout or world-wide risk aversion.  What that means for currency traders, primarily, is an unwinding of the carry trade.  The problems with sub prime mortgages and CDO’s in the United States have some currency analysts suggesting that it may not even take an interest rate hike by the Bank of Japan to end the carry trade.  Investors have even started to abandon US assets for Japanese ones, driving Japanese bond prices to their highest levels since last August, with USD/JPY nearing 122.00.

Dollar weakness is running rampant throughout the currency markets today.  EUR/USD is approaching stratospheric heights with concerns in the dollar compounded by the likelihood of higher interest rates in Europe.  A similar situation (although with better fundamental data) is playing out with the cable, as it crashes through 2.0300.  And the irony is this entire situation is that the US economy is generally pretty healthy.  According to Bloomberg, growth is at the moderate target level and inflation is under control.  Economically, the country is humming along like a trusted old car; it is not going to impress anyone but it isn’t going to give you any problems either.  Despite all that, you might want to stay away from the greenback until further notice.

The forex market has become used to dollar strength against the yen. This year, the yen is the worst performing currency against the dollar among all the highly traded currencies. But there are conflicting opinions as to whether that trend is likely to continue into the second half of the year. The majority of currency analysts call for a push upwards in USD/JPY, but there are some influential voices calling for caution for dollar bulls.

The Non-Farm Payrolls Report came out this morning, and the US economy added 132,000 jobs last month, versus the market prediction of 125,000. Job growth in May was revised upwards from 157,000 to 190,000. Wage growth also picked up, and unemployment remained at the 6-month low of 4.5%. Primarily, this data should signal a rebound in consumer spending, and it confirms the anti-inflationary bias for the Fed. At the very least, growth no longer seems to be a concern, and US interest rates are not likely to go down.

During their meeting last week, the Fed said that the low jobless rate created the potential for inflation. They were expecting a moderate pace of growth, with most economists predicting growth in 2.75% in the second half of this year. Seeing as how today’s NFP Report validates this thinking, the Fed’s hawkish stance on inflation is likely to continue.

And that spells bad news for the yen. Early morning trading today saw the dollar gain the most in three weeks against the yen. While much of this characteristic of overall greenback strength across the board, it also could signal a resumption of the USD/JPY carry trade after some time of profit-taking. The interest rate differential and the differing pace of consumer demand in the two countries reinforce the carry. The yen is also hurt by rising US yields, as treasuries took a beating with ten-year yields going to 5.18%. Also important to note, the ten-year bonds rose faster than the two-year bonds, suggesting an uptick in expectations of inflation.

But dollar bulls are not without significant opposition in the currency market. As first reported by Bloomberg.com, Federal Reserve Bank of San Francisco President Janet Yellen is somewhat dovish on interest rates. She advocates leaving interest rates unchanged for a long time, as that would best encourage growth and discourage inflation. Yellen warns carry traders specifically, arguing that “‘carry trades’…expose investors to ‘substantial exchange-rate risk’ that they may be underestimating.” The low borrowing costs in Japan have created an untenable situation.

Standard Chartered Plc, a London-based bank, does even further in its analysis of a possible carry trade unwind. Currency analysts at the bank argue that volatility in the dollar-yen exchange rate will decline as the interest rate differential closes up. Standard Chartered claims that by the end of the year, US rates will decline 0.25 percentage points to 5.00% and the overnight lending rate in Japan will increase 0.25 percentage points to 0.75%. These two moves, when coupled together, will kill volatility in the currency pair. The final diagnosis is that the dollar will fall to 122 yen by the end of the year.

When the analysis leads to two divergent positions (as we have now), how can we profit? The good news is that most of the disagreement is over the long-term positions of the two currencies. In the short-term, there is a forex market consensus of dollar strength. As Boris Schlossberg of DailyFX.com points out, retail investors in Japan just keeping hopping aboard the carry trade gravy train. We should see the pair test 125.00 soon, and possibly break the resistance on the back of today’s positive data.

Those who thought the US economy was slumping (including me) are wrong.  Or at least that’s what today’s information tells us.  The ISM survey for the month of June reported at 60.7, up from 59.7 in May.  The ADP Employer Report counted 150,000 new jobs this month.  That is a significant increase from the 100,000 new jobs expected this month.

What does all this mean for currency traders?  The job report is important with regard to interest rates.  A number under 100,000 would have been increased speculation for an interest rate cut.  The Non-Farm Payrolls Report is still scheduled for Friday, but today’s news suggests that growth picked up in the second quarter.  Some economists are even suggesting the likelihood of a 3% surge in the economy by the end of the year.

If the Fed does not have to worry about a slowdown in growth, then it can turn all of its attention towards inflation.  We have already seen the importance of curbing inflation on the decisions and comments of monetary policymakers.  Central banks around the world are maintaining hawkish stands in the face of growing worldwide energy prices.  Now that we’ve seen the Fed’s expectations of moderate growth being met, the US dollar should see a rush of support.  The greenback has been up today against both the pound and the euro.  Carry trades should also pick up (or at least continue) as interest rates all over are destined to remain high.

The weakness of the Japanese yen in currency markets has been good news for Japanese companies.  Exports have always made up a large part of the country’s economy, and a weak currency has given the companies a competitive advantage.  But recent reports out of Japan suggest that the yen depreciation might not be all good.  The rise in exports may be offset by higher input prices and lower purchasing power for domestic consumers.  And we have not even considered how politically dangerous the yen depreciation could prove to be internationally.

Trading in the forex market was pretty yen-positive at the beginning of last week.  The first few days were about strength in the Japanese currency, with gains across the board.  But with overall household spending, manufacturing PMI, housing starts and inflationary data all coming in lower than expected, the currency took a nosedive.  Even with this morning’s positive TANKAN release, Japan continues to wage a battle against deflation, preventing the Bank of Japan from raising interest rates.  This allows forex traders to continue to cash in on their carry trades.

Using the real effective exchange rate compiled by the Bank of Japan, the yen has fallen to a 22-year low against the currencies of its major trading partners.  And while that may create a competitive advantage with regard to exports, its costs may be even higher.  Japan imports almost all of its energy needs, and with oil rising above $70/bbl, energy costs for companies skyrocketed 10-20% for Japanese companies.

The undervalued currency also creates problems in competition practices.  Rhetoric regarding an “unfair advantage” (because of the currency) has been ratcheted up both by United States lawmakers and multinational competitors.  The weak currency also makes many companies too dependent on export demand.  Companies are able to do well so easily that it eliminates some of the incentive to improve.  Conditions are starting to approach those of 1998, when the yen gained 10% against the dollar in two days following the Russian debt default.  Mainly because companies had relied too much on easy exports, GDP ended up falling by 2% that year.  A currency that is this undervalued is not conducive to steady future growth, and many companies are starting to realize the problem.  And so the Bank of Japan may actually have some political cover regarding future rate increases this year.

Yen-funded carry trades are not finished, despite reports to the contrary. To paraphrase Mark Twain, reports of its death have been greatly exaggerated. All three commodity currencies, the Australian dollar, the New Zealand dollar and the Canadian dollar, gained against the yen last night. High oil prices and bad Japanese economic data spurred the poor results. Even the US dollar was able to pick up value against the yen yesterday, despite the inaction by the Fed. The yen gains in the forex market earlier in the week now look like a bout of international risk aversion. But with the momentary blip over, yen shorting should resume with a vengeance.

There are many reasons for the current yen weakness. The data released earlier this week was fairly yen-positive. Retail Sales and some investor indices proved encouraging for yen bulls. But the name problem with the Japanese currency has always been the country’s battle with deflationary pressures. The interest rate has been so low for so long, and economic policy makers in Japan are powerless to raise interest rates until growth picks up and inflation returns to the economy.

But the last couple of reports coming out of Japan do not leave much hope for the country. On the growth front, Industrial Production fell 0.4% when most forex analysts were predicting a 0.9% gain. And even more damaging for those predicting an interest rate hike, the CPI report this morning showed a drop in prices of 0.1%. Before final decisions on the yen are made, there is still some data on tap, including overall household spending, the jobless rate and manufacturing PMI. But if deflation persists, the Bank of Japan cannot raise rates in July or August, further dooming the currency.

The yen is easily the most undervalued currency in the forex market, at least among the most highly traded currencies. It has lost 4.3% against the US dollar this quarter. That puts it on track for its biggest quarterly loss against the dollar since 2001. Most of that is due to the popularity of yen-funded carry trades, fueled by the low interest rates in Japan. The majority of currency analysts expect those carry trades to continue to outperform. With the growth and inflation outlook in Japan looking as dire as it does right now, it would be foolish to predict the end of the carry trade wave and the end of the yen slide.

We might be seeing the beginning of a yen rally.  There are a number of factors that point to the unwinding of the carry trade and the subsequent rise of the Japanese yen.  Recent economic data suggests that consumer demand in the Japanese market is finally starting to pick up.  There are growing problems in alternative international financial markets, leaving less attractive options for carry traders.  Lastly, the words and actions of policy makers around the world point to a growing impatience with the forex carry trade.

The main weakness in the Japanese economy over the years (and the factor dragging down its currency) has been poor consumer demand.  That was the primary factor behind the Japanese recession and the multiple years of deflation.  And the failure of the consumer to rebound has prevented the Bank of Japan in recent years from raising interest rates, the primary driver of any currency.  But Japanese Retail Sales just went up 0.5% vs. 0.4% forecast.  This is only one piece of data, but signs point to a greater Japanese recovery.

Another development that does not bode well for forex traders in the carry trade is the downturn in international financial markets.  Equity markets in the United States, Europe and Asia have slowed down in the past week (see DailyFX.com for a take on how the transfer of power in London today will affect the forex market).  Also, greater risk aversion among traders has dampened enthusiasm for high-yielding emerging markets.  There is less possibility for easy growth world-wide, stemming the seemingly voracious appetite for Japanese yen borrowing.

Comments by central bankers have also helped to unwind the carry trade.  RBNZ Deputy Governor Grant Spencer has said that his bank is not done intervening in the forex market to push down the New Zealand dollar.  This is significant because the Kiwi has been a popular partner for the yen in the carry trade because of the 7.5% interest rate differential between the two countries.  Spencer is not the only one warning against the one way bet.  Japanese finance minister Koji Omi is also cautioning trader against relying on that phenomenon.  And Bloomberg has some good analysis on the carry trade effect of the resignation of Japanese finance minister for international affairs, Hiroshi Watanabe.

We have already seen empirical evidence that the Japanese yen is rebounding.  Yesterday, the yen gained against 15 of the 16 most actively traded currencies.  Only Norway’s krone performed better in the currency market than the yen.  As Japanese investors retreated from emerging markets and foreign equities, the yen benefited.  The currency had its biggest gains against the Australian and New Zealand dollar, but it also rose the most in 10 weeks against the euro and the US dollar.  As sub prime problems continue to haunt the US market, the yen is now at 122.42 per dollar and 164.60 per euro.

Recent developments in the foreign exchange market prove that it is not just interest rates that drive action in the currency market.  Expectations of future interest rates also matter.   The currencies with the greatest chance of higher short-term interest rates are the currencies receiving the most support from traders.  The few currencies with bad prospects for an interest rate hike are getting hammered, and that will continue as long as expectations stay the same.  Just look at the results in the last 24 hours.  The pound and the Aussie have been the best performers while the Japanese yen continues to sink.

Much of this kind of activity is indicative of a strong carry trade.  Economic policy makers in Japan have been clear in their refusal to raise rates, at least until there are stronger signs of consumer recovery in Japan.  And when the Bank of Japan does start raising the overnight lending rate, they have committed to doing it as gradually as possible.  Japan’s rates are low, and people (investors) are encouraged to seek higher yields.  The can find those higher yields in other currencies, in the US stock market (witness the steady resilience of the market to any drops) and in foreign bonds.

The carry trade is simply an interest rate differential story.  There is a concern as it becomes more popular because that makes it inherently riskier (see Bloomberg’s stories on Japanese and Hungarian housewives engaging in the carry trade and beating the market).  But until the carry trade bet becomes untenable (and that will happen at some point), forex traders continue to reap their gains and push the yen lower.  The euro is at its highest level ever again the yen.  AUD/JPY is at a 15 year high and USD/JPY is at a 4 year high.  And perhaps most interestingly, the New Zealand dollar, the currency with the highest yield, is back to the rarefied levels it occupied before the RBNZ intervention.  The bank would like to push it down again, but it is running out of funds.  And central bank interventions do not usually work anyway.  The bottom line is that as long as the global market stays calm, carry traders will profit on the interest rate differentials.  But world-wide inflation, political uncertainty, a slowdown in the United States or anything else that throws the forex market into flux will put a wet blanket on the carry trade.

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.