The Week Ahead In FX
Long Live The Carry Trade
2003-2004 was characterized by
the carry trade as pitifully low yields in the US and Japan allowed traders to
sell these currencies (i.e. the funding currencies) and purchase currencies with
far higher yields, most notably GBP, AUD and NZD. While this is still the case,
there are some subtle shifts worth noting that may have implications later in
the year.
Higher yields alone do not
justify a carry trade; whatever is made in yield can be lost in currency
depreciation. A rule of thumb, which has a strong correlation, is that general
economic outlook as well as a contraction in credit spreads (seen as a vote of
confidence) will allow a trader/investor to raise their risk appetite as these
will typically indicate there is more to the trade than yield alone. Given that
these macro economic changes take place slowly, risk appetite will fluctuate,
but will rarely deviate from trend by a large degree. Another factor, that was
in place in 2003-2004 was low implied volatility, hence the risk of holding
these assets decreases, as this is a sign that the overall economic environment
is benign. Which brings us to our point.
Credit spreads are, arguably,
near their lows. However, credit spread changes have a lag effect on currencies,
so it may still be a few months before FX prices reflect any increase in credit
spreads. Credit spread lows will also preceed a reduction in risk appetite;
hence a high yielding currency will need to be viewed by traders based on more
than just its’ yield.
Under this scenario, it is easy
to see that AUD & NZD are fairly valued, while GBP is a touch overvalued.Â
Surprisingly, high yielders like BRL (Brazilian real) and MXN (Mexican peso)
provide an investor/traders both components as described above, yield and a
solid macro back-drop and a reasonable valuation.
Naturally, this analysis has no
immediate trade implications, we still see GBP, AUD & NZD as offering solid
short-term trading opportunities to the long-side, but with rates on the rise in
the US, carry trades versus the dollar may lose their appeal. Look for low
yielding currencies like JPY and to a lesser extent CHF to become part of the
mix going forward. This shift alone would add yet another leg to our belief
that the dollar will move higher in the next few months. Nonetheless,
understanding the dynamics behind longer-term currency movements allows one to
position properly.
The Week Ahead
It will be Alan Greenspan’s
time in the spotlight as FX traders await and dissect each word for any clues as
to the dollar’s near-term direction. He will speak on Wednesday at 10 AM EDT.Â
Regular readers will recall that we saw 2005 as the year where the market would
flip between focusing on yield or current account surplus’/deficits, while we do
not know which will win out in the end, the data released in Japan on Monday
which showed a much larger than expected increase in the current account surplus
took USD/JPY down a quick 50 pips and translated into consistent dollar losses
against all the G10 currencies during the day. This, on the heels of a
fantastic run higher in the dollar just last week. Welcome to FX trading 2005
style. Hence Greenspan’s comments on not only the current account deficit, but
also the implications on foreign investors will be key.
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