Carry and trades

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 , 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 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.