This article will explain how to take advantage of the Fed's QE Infinity policy. It assumes that over the long run, the USD will decline most significantly against emerging market and high interest yield currencies. We will explore a few options how to execute this model U.S. Dollar carry trade portfolio.
Why a portfolio?
Individual currencies may be subject to their own behavior patterns. The USD may trade positive against a currency that has just released positive economic data, or has decided to lower its interest rate. Rather than picking which is the 'best' currency for the USD carry trade, it's more practical to create a portfolio consisting of multiple currencies rather than a single one. The trade here is betting the USD will go down, not that a particular emerging market will go up. That means the best approach for this strategy is to create a basket of emerging market currencies that are readily available.
The investing pairs
We've analyzed various options for this trade and determined the following currencies are best:
- HUF (Hungarian Forint) 5.5%
- MXN (Mexican Peso) 3.5%
- PLN (Polish Zloty) 3.5%
- TRY (Turkish Lira) 4.75%
- ZAR (South African Rand) 4.5%
- SEK (Swedish Krona) 1%
They have been listed in order of our preference (best to worst) with the swap rate as provided by our preferred broker. The swap rate is calculated yearly paid daily at 5pm rollover. Above rates are without leverage (with leverage this can be even more).
Reasons why these currencies were chosen to create the portfolio are that they are liquid, usually available, and have high interest rates compared to others (such as the Czech Krona which would be negative). While the SEK is only paying 1%, it may provide a more stable decline than the others considering Sweden's strong economy.
Some currencies were excluded such as the Chinese Yuan (NYSEARCA:CNY) because it is only available to trade at a few select brokers, with trade restrictions and a high spread. While the above currencies are exotics they still are rather liquid and can be traded the same as the majors.
The borrowing currency is always the USD, so all above positions will be short positions (short USD, long HUF,TRY,SEK,ZAR,PLN,MXN).
How the swap pays
In case you aren't aware of rollover payments in Forex, certain positions will pay interest daily at 5pm NY. Each bank and broker has different rules regarding payment of swap interest, and usually publishes swap rates on their website or delivered privately to clients. These rates will tell you what you get paid (or owe) depending on your position. In the case of the USD carry trade, it's exactly the fact that our positions are paying which will make them also pip - profitable. Other investors will invest in these currencies to receive swap payments. In currencies, it's the only trade that pays you.
In the most basic form, a short position should be taken in the following pairs:
- USD/HUF, USD/MXN, USD/PLN, USD/TRY, USD/ZAR, USD/SEK
The trade should be sized according to your risk profile. In the most basic risk profile, a 1:1 leverage can be used on each trade such that if you have 100,000 in your account you would place a short position of 100,000 USD/HUF and so on. This would give you a total of 6:1 exposure on the USD decline. Each trade should have a stop loss of about 2% of the trade value. Ideally, this should be traded with no stop loss as this is a long term trade. The trade could last several years, meanwhile you are accumulating interest payments.
In a more active portfolio, you could immediately take the above simple portfolio positions, but with the expectation to sell more on any spike up. Like any instrument, timing is key. While the portfolio will likely decline over time, there will be small jumps up here and there that will eat into the overall profit. If you are an experienced trader, you can use indicators to determine sell points. In some of the pairs this might prove difficult however because the overall trend is down.
You can see there would be few sell signals based on indicators such as RSI, because the overall trend is down. The point is, an active trader can use his own preferred methodology for picking entries, but always with the same position (short USD/cross).
Swap leverage benefit
If you can bear the brunt of the swings in a pair such as USD/HUF, and could use 10x leverage, the trade would pay 55% per year, regardless of where the USD/HUF price was. Similar to a dividend paying stock, if you can afford to you can sit on this trade and keep getting paid.
How to trade it
The ETF offering of some of these currencies is unfortunately limited. There is South African Rand (NYSE:SZR) and you can obtain exposure to some others with the Emerging Currency ETF (NYSEARCA:CEW) however these options provide less trade value and do not pay swap. Ideally this trade should be traded as a spot forex transaction but could also be traded with Futures. For information about opening a spot Forex trading account click here.
What can happen with this trade is that it can at some point seem "too good to be true." As other investors jump on board it will create even more pressure on the pairs, creating more profit for those who got in the trade early. This can "unwind" quickly for any number of reasons, such as happened to the last JPY based carry trade. To protect yourself from this happening, you will want to use stop losses but more importantly, keep abreast of the news and developments. When the JPY carry trade unwound, there were clear signs and rumors spreading in financial news media. If you are an options trader, another way to protect from the downside risk of this trade would be with deep out of the money options long USD/cross.
(Forex Risk Disclosure - Click here to read)
The risk of loss in trading foreign exchange markets (FOREX), also known as cash foreign currencies, or the FOREX markets, can be substantial.