From the October 01, 2008 issue of Futures Magazine • Subscribe!

Return of the carry trade

The recent collapse of carry trades and the subsequent calls for renewed decline in the dollar should put the "carry trade" on every trader's mind. The carry trade consists of purchasing a foreign exchange position with a positive interest rate differential. You are buying a currency of a country with higher interest rates against the currency of a country with lower interest rates. You earn interest on the positive carry. All things being equal, as more people buy the currency pair for the positive rate differential the price of the currency pair also goes up.

As the July to September decline in all carry trades proves, the timing of your entry and exit is critical. Moreover, often overlooked is the need for strong fundamental background in the currency you are buying and a weak fundamental background in the currency you are selling. Perhaps one of the best "carry trade" setups against a renewed fall in the U.S. dollar is to be long Mexican pesos and short U.S. dollars.

Mexico is a newly industrialized country and the 12th largest economy in the world by GDP in terms of purchasing power parity. Given that tourism is the second most important driver of GDP, at 10% of GDP, and the main source of foreign exchange reserves just behind oil exports, the peso gains strength from foreign exchange inflows. The peso at 7% interest paid is also one of the only high yielding currencies that is currently undervalued against the weak dollar.

Half of all visitors to Mexico are from the United States. Tourism traffic has not slowed but expanded sharply since 2001 and is expected to increase 50% by 2020 to 150 million annual visitors. By these trends, Mexico's tourism growth rate is the second fastest in the world and Mexico will soon become the fifth most visited global tourist destination and the second most visited country in the entire Western Hemisphere.

Due to the dollar's ongoing strength against the Mexican peso after a swift decline earlier this year and Mexico's close proximity to the United States, we look to sell USD/MEX at the 109000 area to work a short and target 105000 to take profits.

The technical setup on the USD/MXN provided us with a very inviting short setup on a weekly chart as we approached a key downward trend line that goes back to the middle of 2006 (see chart below). We truncated the spike high in the middle of 2007, as it provided us with an overlay at the .618 retracement near the 109 level. We believe that we will see a move lower to the 104 level where the 15-week moving average is turning up and make another attempt at this downward trend line. From there, we are looking for a failure over the coming months of this level and for the USD/MXN to test the lows at 100. This set-up offers a multitude of trading opportunities and when combined with a strong fundamental backdrop goes a long way in helping someone earn profits. The positive interest rate differential also provides an added safety net if we are wrong on the timing or strength of the move.

Jes Black is Managing Director of Black Flag Capital, a CTA with$150 million under management. He has co-founding NetBlack Capital with John Netto, and has worked as a chief currency analyst on Wall Street. .John Netto is Chief Investment Strategist of NetBlack Capital and author of One Shot--One Kill Trading: Precision Trading Through the Use of Technical Analysis.

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