One sure sign that some level of stability is returning to the global economy is an easing of the volatility we have seen with many of the major currency pairs. As any currency trader will tell you, volatility is a double-edged sword Ã¢â‚¬â€œ it is possible to earn very attractive returns during periods of high volatility, but losses can be equally as spectacular. On the other hand, when exchange rates remain steady for a prolonged period, it may be easier to keep a lid on losses, but opportunities to profit are also limited. This is why when exchange rate volatility declines, many traders turn to the carry trade.
[mserve id=”Central_Bank_BOJ.jpeg” align=”left” width=”400″ caption=”Bank of Japan” alt=”Central Bank of Japan BOJ” title=”Bank of Japan”]
A carry trade strategy seeks to profit from the interest rate differential between two currencies. The approach is to select a currency pair where you sell (go short) a currency with a low interest rate, while simultaneously buying (going long) a currency with a higher interest rate. When you hold this currency pair open in your trading account, you must pay interest on the short position, while you receive interest on the long position. If you receive more in interest than you pay, this difference Ã¢â‚¬â€œ known as interest rate carry or simply carry Ã¢â‚¬â€œ is retained in your account as profit.
Now before you jump to the conclusion that this is as close as you can get to earning money for nothing, there is one important caveat you must consider. The entire time you hold the currency pair open in your account, the value of the trade itself is subject to changes in the exchange rate; this means that if the exchange rate moves against you, and even if you are earning positive carry during this time, you may actually lose money overall when you close the trade.
For much of the early 1990s, Japan had the lowest interest rates of the major currencies and entering into a carry trade using the yen to buy higher yielding currencies was very popular. The practice became less attractive during the mid 2000s and was put on hold entirely during the current economic crisis. In 2009 however, the carry trade came back with a vengeance, as Australia and New Zealand raised interest rates to 3.75 percent and 2.50 percent respectively, and this had many traders selling US dollars in order to buy aussie and kiwi dollars.
In addition, both currencies also fared vary well against the dollar from an exchange rate standpoint as you can see in the following table:
|Currency Pair||Rate as of Jan 1, 2009||Rate as of Jan 1, 2010||*Percentage Change|
|AUD / USD||0.6539||0.8929||36.54%|
|NDZ / USD||0.5786||0.7255||25.39%|
|USD / CAD||1.2184||1.0505||15.98%|
* reflects the percentage change in the value of the non-USD currency compared to USD
2009 Carry Trade Winners
The chart confirms that both the Australian and New Zealand dollars were clear winners over the US dollar during 2009. If you had held the AUD / USD and NDZ / USD pairs open for the entire year, you would have gained 36.5 percent on the aussie trade, and over 25 percent on the kiwi position just on the exchange rate change alone.
In addition to these impressive returns, you would have also earned the interest differential, which for most of last year, was 3.5 percent for the Australian dollar and 2.25 percent for the New Zealand dollar. Interestingly, the Canadian dollar also earned nearly 16 percent over the US dollar on the exchange rate difference, but with a 0.25 percent overnight rate, the Ã¢â‚¬Å“loonieÃ¢â‚¬Â offered little in the way of carry over the US dollar.
Now for the big question Ã¢â‚¬â€œ is the carry trade still in play for 2010?
This answer depends very much on the strength of the recovery. If the economies of China and India continue to expand at their current rate, and if the US and Europe maintain at least some limited growth, the so-called commodity currencies (Canada, Australia, and New Zealand) are well-positioned to remain strong in comparison to these other currencies. Having said this however, it may well be time to find a new banker to provide the funding for these purchases.
By this I mean, instead of selling US dollars and buying aussie dollars for instance, it may be better to short the yen, and there are very good reasons for making this consideration. Firstly, the US dollar could gain in strength later this year, and if this were to happen, there is a chance that the Federal Reserve could raise interest rates by yearÃ¢â‚¬â„¢s end. Japan on the other hand, is fully committed to a policy of maintaining a weak yen for the foreseeable future.
Driving the value of the yen downwards is an attempt to make JapanÃ¢â‚¬â„¢s exports more attractive to foreign markets Ã¢â‚¬â€œ particularly the United States and Europe. The goal is to boost exports to help keep JapanÃ¢â‚¬â„¢s all-important manufacturing sector busy and to prevent further job losses. For an export-dependant economy such as JapanÃ¢â‚¬â„¢s, the trade-off of a weaker currency to preserve production levels (and by extension reducing unemployment), is a small price to pay.
Obviously, the Bank of Japan has used up its interest rate arsenal and can no longer simply cut rates in a bid to weaken the yen. Thus, the only option left for the Bank is to boost the supply of the currency by dumping even more yen into the system. If you listen carefully, you can hear the humming of the printing presses.
This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.