From the May 01, 2011 issue of Futures Magazine • Subscribe!

Is the “carry trade” coming back?

The most important current fundamental for forex traders is the anticipation of an exit strategy from extreme accommodative policy in the West. When will quantitative easing and related monetary stimulus in response to the global credit crisis end? The central banks of the G7 are at a point where they are looking at ending stimulus and beginning to increase interest rates to slow down inflation, which depending on who you are talking to already is here or on the way. Some already have increased rates, and those that have not now are facing a post-quantitative easing era. Now is the time to prepare trading strategies that can benefit from this historic shift.

A key step for the forex trader is to realize that a change in interest rate policies across the globe will create ripple effects in almost every currency. When interest rates go up in one country, an imbalance is created in capital flows throughout the world. It is not necessarily the actual interest rate level that is important, but the anticipation that rate increases will continue; that attracts even greater demand for the currency. This is because of the "carry trade" where low-interest currencies are sold or borrowed against and the capital raised goes to the higher-interest-rate currencies. The carry trade collapsed in 2008 as capital had to be repatriated back by the borrowers who had to pay off bad debt. The yen, which has been a favorite funding currency in the carry trade, took a big hit when heavy yen buying followed the tragic earthquake in Japan earlier this year.

That was more of a temporary psychological reaction than one driven by interest rate fundamentals. The yen, with G-7 intervention, resumed a weakening direction and the yen carry trader, in-effect, has reappeared as a weaker yen is technically and politically favored. An easy way to detect the resumption of the carry trade as a strategy is to watch the iPath Optimized Currency Carry ETN (ICI). ICI is designed to reflect the total return of an "Intelligent Carry Strategy" and is now forming a triple top at $47. If it breaks out, it will be a clear signal that global conditions favor a carry trade revival (see "Back to the carry"). The challenge for the forex trader is how to participate in this powerful force.

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For traders to take advantage of increased interest in the carry trade, they must closely monitor interest rate differentials. When one currency is actually increasing rates while another is not, capital will flow away from that currency to seek the higher return. Following this pattern, several currency pairs can be traded to take advantage of carry as well as to anticipate increased differentials. For example, the EUR/GBP crosspair is likely to strengthen — if the European Central Bank raises rates and the Bank of England does not. Similarly the Swiss franc, a low-yielding safe-haven currency that has strengthened against the euro by over 3,700 pips in the last four years, finally may be able to weaken. The Swiss central bank desires a weaker currency and may keep rates low as the ECB raises rates.

The yen is likely to keep its status as the lowest yielding currency and as a result the AUD/JPY and EUR/JPY cross-pairs will receive the benefits of bullish sentiment. If rate increases in the G7 continue in the coming months, the Brazilian real will become more vulnerable to a sell off. Even though its interest rate is at an astronomical level of 11.75%, a change in its differential with other currencies may be the tipping point for weakening this currency. However, when it comes to the U.S. dollar, the situation is more tentative. The U.S. dollar is still a low-yielding currency and also may suffer from the carry effect. Yet, if Fed Chief Ben Bernanke signals the end of quantitative easing or signals vigilance on inflation, the U.S. dollar may attract investors and traders anticipating a potential rate hike. In any case, interest rate differentials and expected changes in interest rate differentials, rather than risk aversion, will become the major fundamental force for traders to contend with in the coming year. Forex traders should watch out, as the carry trade offers some extraordinary opportunities.

Abe Cofnas is the author of "Sentiment Indicators" (Bloomberg Press). He can be reached at abecofnas@gmail.com.

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

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