Category — Carry Trading

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. 

The primary market mover on June 11 was RBNZ’s intervention in the currency market to drive the Kiwi lower.  The central bank’s decision to sell the currency did move the New Zealand dollar lower against most major currencies.  Following up on that story, the Kiwi has shown signs of a rebound from yesterday’s lows.  The country still boasts the highest interest rates among highly-traded currencies in the forex market.  As such, the Kiwi is attractive to institutional investors, including multinational banks and pensions funds.  But most currency market analysts believe that if the currency appreciates again, the RBNZ is likely to intervene in the foreign exchange market again.