special reports

How Much Longer Can Carry Trades Last?

Tuesday, 17 April 2007 18:57:01 GMT  |  Antonio Sousa, Currency Analyst

The foreign exchange market is obsessed with the carry trade.  With EURJPY soaring to and all time high and NZD/JPY moving nearly 15 percent in the past six weeks, the carry trade has paid off handsomely for many traders.  However, many people may not realize that that the rules of the carry trade game have changed.

The massive unwind of carry trades on February 27, 2007 was both a reminder that riskless trades don’t exist in the FX market and a warning sign that economic fundamentals do matter. The frightening events on February 27th showed that even though interest rate differentials are fundamental to the carry trade, they are far from enough for the trade to succeed. What really makes the difference between good and bad carry trades are interest rate expectations.

The Progression of Carry Trades in 2007
Looking at the interest rate term structure for some of the most liquid currency pairs, one can easily see why the Australian and New Zealand dollars are becoming the most sought after currencies in the carry trade world. Not only are both the Australian and the New Zealand economies benefiting from a recovery in commodity prices, but as a result market expectations are clearly skewed for more rate hikes. Taking a snapshot of the interest rate term structure for deposits denominated in Australian dollars (table shown below), one can see that while the overnight rate offers an already attractive 6.25 percent, the 3 month rate is 6.53, implying a rate hike over the next few months. In addition, the 2 year rate is actually offering 6.64%, a premium of 34bps above the current level of rates, implying that the Australian central bank could remain hawkish for most of 2007. The interest rate outlook for the New Zealand dollar is slightly different. While the overnight rate offers 7.5 percent and the 3 month rate is priced at 8.02, 2 year rates only offer a 3 bps premium over 3 months rates implying that the RBNZ could hike at its next monetary policy meeting and then stop. Market players will always seek the highest return for their investments and just because the USD/JPY carry trade doesn’t work as well now as it did in the past, doesn’t mean that the entire carry trade strategy is condemned. The new rules of the carry trade require that you find currencies with both high interest rates and positive interest rate expectations.

Is the USD/JPY carry trade condemned?
Until very recently, long USD/JPY was the trade that everyone wanted to be in. While the Federal Reserve, struggling to control inflation, increased the price of money sixteen consecutive times, the Bank of Japan was fighting deflation by holding interest rates near zero. Consequently during 2006, the interest rate differential between US and Japan made long USD/JPY a one way bet. However, on February 27, 2007 all those gains and assumptions about the carry trade logic came to an end. An unexpected unwind of yen carry trades triggered both by a sell-off in the Chinese stock market and by rumors of margin calls affecting leveraged accounts, pushed the Japanese yen to record lows against the world’s most liquid currencies. Looking ahead, the yield curve shown below makes clear that even though the US dollar still has a positive interest rate differential against the Japanese yen, interest rate expectations are visibly favoring the Japanese yen, what makes the USD/JPY a bad carry trade for 2007.  Furthermore, the dollar could become the epitome of anti-carry.  Many traders expect the Federal Reserve to start cutting rates and are currently hunting high yielding currencies like the Aussie and the kiwi at the cost of the US dollar.  Since the beginning of March, both the Australian and New Zealand dollars have surged over 650 pips against the US dollar, which is the equivalent of 8.5 percent in Aussie and 10 percent in the kiwi.

The AUD/JPY May be the Best Continuation Carry Trade for 2007
While the Japanese economy continues to be very vulnerable to the economic cycles of the US economy, the Australian economy is on its sixteenth consecutive year of strong growth. The Australian economy, the world’s 12th largest is running at full capacity, continues to profit immensely from the emergence of China and India and has been benefiting from a recovery in both gold and coal prices. Australia's two year government bonds yield 5.48 percentage points more than similar Japanese bonds and have a 1.77 percent premium over U.S. As a result of this large differential, in just 12 months the Aussie climbed 15 percent against the Japanese yen, trading from a low of 82.07 on March 2006 to as high as 99.90 in April 2007, as Japanese investors bought Australia’s higher yielding assets. The chart below illustrates the close correlation between the price action in AUD/JPY and the 12m interest rate spread of Australian and Japanese Yields. Although the cost of borrowing in Australia is already among the highest in the world, unless price and wage pressures start to fade away the RBA could be poised to increase the level of interest rate to a 10 year high which would help the AUD/JPY break the 100 price barrier.

For our outlook on the Australian Economy, please visit http://www.dailyfx.com/story/currency/aud_fundamentals/2007_Second_Quarter_FX_Market_1176239005787.html

How to stay on top of the Carry Trade Wave?
The carry trade strategy has been very successful over the past few years. Still, one should keep in mind that this type of trading involves significant risks and an active management of the basket is required to avoid any significant drawdown’s. Making profitable trades using a carry trade strategy is more than selecting the currencies with highest yields. One needs to keep an eye on interest rate differentials, bond yields, stock market and speculative positioning. Because not all of us are professional traders we created a dynamic carry basket that changes when the monetary policy outlook for a central bank changes or if there is significant event risk ahead.  You can follow the performance of our Dynamic Carry Trade Basket weekly on DailyFX.com and daily FXCMTR.com

To find out more about DailyFX Dynamic Carry Trade Basket please visit:
http://www.dailyfx.com/story/special_report/special_reports/DailyFX_Dynamic_Carry_Trade_Basket_1176225916909.html

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