Currently, interest rates are still scraping recent historical low and there are significant pitfalls that could spark a second wave of fear and flight to safety. On the other hand, with rates essentially on a level playing field and the concept of safety dramatically altered by the events of the past few years, the response to such a dire turn for the market could be substantially different. With the markets looking to enter a new phase, we will cover the risk and reward of the traditional carry trade strategy and then talk about how it can be used in today’s markets.
To get to the point the market is at now, the once-popular carry strategy was wrung for both risk and return. When the financial crisis was really hitting its stride through the end of 2007 and into 2008, the sheer panic was driving the markets. Investors were looking to transfer their funds not from a risky asset to a risk-free one – they were still trying to find an alternative with a high return. However, when liquidity seized, the realization of just how dire conditions had become dawned. The exodus from speculative positions and instruments was immense; and only recently have we seen interest in high yielding currencies return. It is true that the ‘basing’ period of the past six months has passed without the threat of another major bankruptcy, default, or liquidity crisis. Does this mean the path is free and clear for a return to pure carry? No. There are still bigger concerns looming; and any one of them can stoke fear.
Recessions Are Still Prevalent – Speculative interests often spurn the present in expectation of a greater source of return later down the line. However, traders may have to wait a long time and suffer significant drawdowns along the way if they start calling for positive growth, earnings and capital investment now. Most, timely data to this point has offered only improvement in pace, not in absolute terms. For example, consumer confidence indicators from many of the world’s leading economies have stepped up from multi-decade lows; but are still under water. More discouraging is the general pace of growth data. Japan recently reported its worst contraction on record and US officials recently downgraded their projections for 2009. Should expectations for a late-2009, early-2010 return to growth fall apart so too will trader sentiment.
Government Aid – Dealing with a state of financial disaster, the world’s governments were forced over the past few years to inject liquidity into the market, extend guarantees on corporate debt, buy shares, nationalize banks and take trillions of dollar worth of toxic debt onto their books. This has led to tremendous, fiscal strain for the world’s largest economies (which has even begun to threaten the stability of some stalwart nations). Though policy makers acted quickly to put out the financial fire; they did not do so without mind to the eventual ‘exit strategy.’ At some point, the stabilizers will be removed from the market; and we will see if the market can make it on its own. Without doubt, the greatest threat to in the government’s exit is the rotation of toxic assets back into the market. Asset backed securities (ABS), mortgage backed securities (MBS) and other illiquid, hard to value derivatives were accepted as collateral so banks could draw liquid funds. As the worst seems to have passed, central banks will be eager to push these securities off their balance sheets; but they will have to do so with finesse and incredible sensitivity as to how their actions are impacting market sentiment.
Regulations Will Stifle The Recovery – Many believe that the worst global economic crisis since the Great Depression was borne from a lack of regulation and responsibility. Law makers certainly fall within that category; and while trying to stabilize the 2007-2008 crisis; they were simultaneously drafting policy to prevent such a cataclysmic event from happening again in the future. In their zeal, however, the markets may flounder. The government’s presence in the market is a natural dampener as their desire is to dampen absolute volatility. They do so by tempering leverage, reducing credit, influencing rates of return, and generally boosting regulation. It seems may seem relatively benign to suggest that accounting rules will be changed to promote transparency; but this could in fact have a tremendous impact on sentiment. In the US, FASB (the Financial Accounting Standards Board) passed rules that would require banks to report billions in additional losses taken on assets and liabilities that were left out in previous earnings.
Interest Rates: The Promise of Returns
For any strategy to work, it has to have an acceptable balance of risk and reward. Over the past two months, carry interests have rallied largely on the presumption that the threats to financial stability have been rectified. However, there can never be a sense of certainty as to how risk develops; so speculators must be compensated for the danger of losses with the allure of comparable returns. In a setting of pervasive recession and cautious investing though, what kind of returns can be expected?
In the table below, we are given the current level of the benchmark Libor rate. This is a better representation of fundamental returns than overnight lending rates. After months of policy easing, the world’s rate of return has depreciated substantially. Interest rates that were once near 9.5 percent in New Zealand, 5.5 percent in the US and 6.5 percent in the UK are now mere shadows of what they used to be. Not only is this meager compensation when considering the potential for another crisis; but it offers little in the way of yield differential. The greatest premium among the eight most liquid currencies comes with AUDJPY; yet this pair is extremely volatile and there is the specter that the high-yield component can be further deflated through a grinding recession. In the ‘Adjusted 3 Month Libor Rate’ column, we have adjusted the current rate to include the expected change in the benchmark over the next 12 months.
How to Use the Carry Trade in Today’s Market
Whether you believe the bullish turn in the market is genuine and we have embarked on the next bull wave or the imbalance of risk to return will weigh speculation for months to come; there is a means to use the traditional carry trade in your strategy.
Interest Bearing: For the first scenario, we will take the optimists’ approach. Should the promise of positive growth eventually translate into greater returns, we will see not only yield income rise but capital gains (as funds are put behind this strategy) as well. In this setting, the most appealing trades will be those that will see their interest rate differential expand rapidly. This requires going long a currency whose benchmark lending rate is already relatively high and is likely to rise quickly; while the opposing (funding) currency will see its target rate hold relatively steady through the most aggressive times. From a fundamental perspective, the Australian dollar is the best candidate for the high-yielder as its economy has suffered a relatively mild slump and the RBA has signaled its intent to dampen its easing regime. Alternatively, the list of low rates is broader. Specifically, the Japanese yen, US dollar and Canadian dollar maintain extraordinarily low rates and their respective policy groups have expressed their intent to keep them that way into 2010. However, of the three, the yen wins out with more than a decade of interest rates below 0.25 percent.
Aligning Speculation: The other method for using carry in your strategy is aligning a pair to the general prospect of rising or falling sentiment. In its most basic form, the carry trade is merely a reflection of trader confidence; and this is a particularly engrossing theme for the markets now. As such, we will look for the currencies most sensitive to interest rate changes. In the bullish scenario, we have already established that the Australian dollar is the most likely to appreciate while the greenback, Canadian dollar and yen are most likely to maintain their pace. In the situation be the opposite and general rates of return be encouraged to fall, the US and Canadian dollars will receive flows as their rates are already as low as they can go (which indirectly means their respective policy officials are willing to do as much as they can to encourage growth). At the same time, the Australian dollar will see its benchmark stumble; but it is the fundamentally weak New Zealand target rate that threatens to drop the quickest.
Written by John Kicklighter, Currency Strategist
Article Source - Is The Carry Trade Recovering?
What is Forex?
The foreign exchange market (Currency, Forex, or FX) is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. Forex transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. The foreign exchange market that we see today started evolving during the 1970s when world over countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971.
Today, the Forex market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Traditional daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements. Since then, the market has continued to grow. According to Euromoney's annual Forex Poll, volumes grew a further 41% between 2007 and 2008.
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This enormous market is like the dangerous sea where you can meet lots of sharks and dangerous waters but at the same time it is the only one where two weeks of trading can hypothetically bring you $1,000,000 out of $1,000 of initial investment.
This is certainly hypothetically because a lot of newbie traders deal with their trades as gambling, that surely bring them to having nothing in the end. You should always keep the phrase "be careful!" in your mind. This market would give you its profit possibilities only if you learn the basic things hard and make lots of demo trading.
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Hope this has answered a lot of questions you were asking yourself about Forex and that you can now start trading. Also make sure that you check out other articles on this blog which can help you earn your fortune.
Good luck to everyone!