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The Carry Trade: RIP

The post-credit crisis rule book has been re-written, a new year begins with sovereign downgrades, and the ink dries on another central bank debt program, which has created plenty of nuances for inexperienced traders to learn, and an old habit to kick.

One of the most vaulted terms used from 2005 through to 2009 was the Carry Trade, as in; “Traders unwound the carry trade today”, or “Positive trading saw the carry trade bought today”, referring to the use of spot currencies to earn/pay overnight swap interest in-line with equity market risk outlooks.

The carry trade however has become a distant memory, unable to perform its core duty in light of reduced inter-bank liquidity, and impacted by the fear-of-loss that permeates through regional market open and closes. But what has happened to the carry trade and its JPY/S&P correlation?

The interest rate differential between central banks, (the difference between the Bank of Japan overnight rate, compared to the Fed overnight rate) has always been something that pushed markets to sell JPY in risk tolerant trading (long-equity environment), and buy JPY in risk averse trading (long-bond environment).

The value of the Japanese yen (JPY) strengthened from a low against the US dollar in June 2007, to a high in March 2011, because for the first time in decades it became as cheap to borrow USD based funds as it was to borrow in Japanese yen-based denominations. The strength of the yen’s move can be seen in the USD/JPY cross pair, that hit a high of 124.00 in June 2007 (USD strength), to a low around 75.50 in October 2011 (USD weakness).

From March 2006 the Bank of Japan overnight interest rate moved from 0.0% (while the Federal Reserve rate was at 4.75%), to a peak of 0.5% in September 2008, (while the Federal Reserve rate was at 2.0%), to the current 0.1% rate (while the Federal Reserve rate held at 0.0-0.25%),

After the global central banking community dropped rates towards Japanese levels over the last three years, the yen was valued on the strength of growth forecasts, rather than being dominated by interest rate differentials. After seeing global interest rates similarly aligned to Japan, the Carry Trade and JPY's inverse link to equity direction became a little tenuous, and that outlook will remain the same until global interest rates climb while Japan stays in a stagflationary economic cycle.

The reality is, when central bank interest rates converge in a race to the bottom and offer little interest rate differential, the Carry Trade becomes inefficient, offering little upside when compared to the base cost. There is only one main economic region (Australia) that offers an interest rate differential at this time.

A position that is long AUD Australian dollar and short JPY Japanese yen, (Long AUD/JPY), will earn interest each day at 17:00 ET when swap interest is rolled into the new trading day. A position that is Short AUD/JPY will pay interest to hold that position past 17:00 ET.

As a high-level example, the Australian central bank interest rates at 4% compared to the Japanese interest rate at 0.1% creates a 3.9% annual interest rate differential.

The 3.9% (annual rate) divided by 365 days a year equals 0.01% interest earned/paid on long/short AUD/JPY

The smallest off-exchange currency denomination that pays interest is a mini-lot, which controls 10,000 units of the base currency

A$10,000 x 0.01% = A$1 of swap interest earned/paid each day

Compare the A$1 a day rate in AUD/JPY (which can be easily eaten up in spread and currency movement going against the position) to the EUR/JPY rate on the same trade, which would create a 0.20c differential. It becomes very clear that earning swap interest and creating a Carry Trade needs to be part of the cost of doing general business, rather than a stand-alone strategy.

Understanding what makes up cross pair trading values on the Japanese yen offers another insight into what happened to the Carry Trade. The value of any JPY cross pair is determined by the percentage change in USD/JPY compared to the percentage change in the dollar-based major currency that is being traded against the JPY.

For example; Eur/JPY (97.47) is made up of the value of EUR/USD (1.2675) multiplied by USD/JPY (76.90):

1.2675 x 76.90 = E/J @ 97.47

The USD/JPY valuation determines the overall market value on the Japanese yen in other cross-currencies. The Japanese Finance Ministry will be looking to address the strengthening yen, as seen recently with open market intervention that saw a 300-pip move in a matter of minutes, at a time that economic growth in Japan still has many questions to answer

JPY cross-pair trading has unique traits that follow the moves in the main cross-currency moves against the USD. JPY cross pairs only move as a consequence of the moves in the USD based majors and as such the technical reads should be taken on two pairs; the JPY cross, and the USD major. A spot-currency pair that does not have the USD on one side or the other is referred to as synthetic pairs, as their value is derived from the movement in two other major currencies.

If USD/JPY does not move, then the JPY cross-pairs will only be able to replicate the USD-based moves in the major currency. When USD/JPY  is stuck in tight ranges, JPY trading becomes volatile without being able to break and to some degree becomes pointless until  USD/JPY  starts to move in the same direction as the major pair.

Sustainable moves in EUR/JPY will only happen when both USD/JPY and EUR/USD are moving in the same direction. If USD/JPY is going down (JPY strength), and EUR/USD is moving up (EUR strength), the moves in EUR/JPY will be negated, as both currencies are gaining on the USD at a similar rate. 

The spreads are higher on JPY cross pairs and the volatility increases because of the price-average leverage across two pairs. When USD/JPY is stuck in a range it equates to trading JPY cross-pairs with 200% increased spreads, incurs increased volatility, and offers a lack of stability over and above a regular trade on a USD-based major currency.

USD direction, USD/JPY sentiment, and overall major pair momentum has to be factored in at the time that a JPY/Cross-pair ticket is placed. The JPY cross pairs have their own nuances to work with and their own specifics of times to place, which are normally around the regional market opens and closes. Blanket JPY/Cross-pair trading will not be as reliable a trade when compared to choosing just one currency against the yen that is backed by strong momentum against the US dollar.

Whether the JPY Carry Trade will ever be back in vogue will depend on whether global interest rates move higher en-block at the same time Japanese economic outlooks remain cloudy. Until that time any yen cross-pair trading needs to be selective, and with a defined plan, because JPY is called The Dragon for very good reason. 

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