With the almost certain volatility that forex markets are ready to experience into the end of the week, many traders are looking for ways to establish longer-term positions that could benefit through the summer months. One traditional strategy during this period (which is often marked by reduced liquidity and volatility) is the carry trade, which allows for increased gains based on yield differentials. The usual vehicle to implement these trades is the Japanese yen, the value of which can be tracked using the CurrencyShares Japanese Yen Trust (NYSEARCA:FXY). Given the historically low interest rate yield in the yen, longer-term investors can fund the purchase of higher-yielding currencies (such as the New Zealand or Australian dollar) and pocket the difference.
But the 2013 has been different, and, at this stage, it is not entirely clear that carry trade strategies will be profitable by the time September rolls around. Because of this, it will be critical to watch the language used by Fed Chairman Ben Bernanke during his testimony to Congress. On the whole, any evidence that the Fed is willing to prolong its tapering of stimulus will be beneficial to stock markets, which have a high positive correlation with upward moves in carry trades. In short, commentary that is supportive for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) will be beneficial for carry trades as well. This means bullish moves in the CurrencyShares Australian Dollar Trust (NYSEARCA:FXA) and downside pressure in the CurrencyShares Japanese Yen Trust.
Bank of Japan Impact
So, while the Bernanke testimony will give traders a good indication of how carry trades will perform into the end of this week and month, it is also important to monitor the activity of both the Bank of Japan and the Reserve Bank of Australia. This is the best way of determining the longer-term prospects for trades that are based on the upside potential in the AUD/JPY forex pair. First, the unprecedented stimulus program implemented by the Bank of Japan is still in its early phases, and the country's economy is still well below the 2% target inflation rate the program was meant to create. The latest policy meeting from the Bank resulted in no change to these stimulus programs, but the longer term trends are clear as the finance ministers are clearly set on weakening the currency in favor of its export companies.
On the other side of the equation, we have diverging activity from the Reserve Bank of Australia. This month's monetary policy meeting resulted in no change to interest rates. But what was most important for forex markets was the accompanying policy statement, which greatly altered the bearish outlook on the currency. Specifically, the statement was much more upbeat than analysts had expected and the likelihood of another drop in interest rates this year has been reduced dramatically. High interest rate yield is one of the principal sources of attraction for the Australian Dollar, and one of the biggest benefits for those holding the CurrencyShares Australian Dollar Trust. Supportive comments this week from Ben Bernanke will add to the bullishness and greatly improve the prospects for the remainder of the summer period.
Price activity in FXY is falling once again to pressure major support levels at 94.20. This is starting to look highly likely given the recent failures at resistance. Any further support breaks from here should bring fresh bearish momentum in FXY.
Recent downtrends in FXA are starting to show the potential for reversal after prices gapped above critical resistance at 91.95. This opens the scope to massive potential upside, as resistance levels at this stage are few and far between. Prices are also emerging from oversold territory, which supports the bullish bias.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.