Daddy, is the Carry Trade a Goner?

♠ Posted by Emmanuel in at 8/16/2007 04:13:00 PM
As markets worldwide swoon like teenyboppers at an Elvis concert due to the realization that risk exists after with the US subprime contagion spreading to parts unknown, one of the favorite leveraged plays is quickly fading. The underlying mechanics of the so-called "carry trade" are not difficult to understand: Borrow in a low-yielding currency like the Japanese yen whose O/N (overnight) rate is 0.50%, convert the proceeds then lend in a high-yielding currency like the Australian dollar (AUD yielding 6.50%) or better yet the New Zealand dollar (NZD yielding 8.25%). Although it depends on the actual borrowing and lending rates you obtain, you'd pocket about (6.50%-0.50%=6.00%) on the Aussie carry trade or (8.25%-0.50%=7.75%) on the Kiwi carry trade--assuming that the AUD/JPY or NZD/JPY exchange rate keeps steady. If these currencies strengthen against the Japanese yen, then you earn more off FX gains.

Conversely, there is always a danger, underappreciated perhaps in recent times, that the AUD or NZD can weaken against the JPY. If these decline more than 6.00% (AUD) or 7.75% (NZD) respectively against the yen, then the interest rate carry would be more than negated by FX losses. The subprime crisis is putting trades of this sort under duress as risk is being reassessed. The JPY is quickly strengthening and the AUD and NZD quickly weakening as speculators fear this scenario of losing whatever possible interest rate carry because of FX losses. Have a look below at this six-month daily chart for AUD/JPY (click for larger image). As you can see, this trade has undergone a major "correction" (I just love that term: if markets undergo "correction," doesn't that imply they were "wrong" to begin with to go up by so much?) Also, notice that the relative strength indicator (RSI)--whose overbought and oversold levels are set at 70 and 30 respectively here--is at a way oversold level of 19.30. Talk about everyone heading for the exits of the carry trade at the same time, especially today with that long, long downward line. Everybody is flooding out of AUD/JPY because the drop in this price is already -6.2% so far today alone--which is of course greater than the interest rate carry of 6.00%:

Even the plain old NZD/USD (not NZD/JPY) is heading south in a hurry. Being a hardcore US dollar bear, I read the dollar's recent strength in the wake of the subprime crisis as not a sign of the dollar being a "safe haven" in times of trouble. If the dollar is a "safe haven," downtown Baghdad is a "zone of tranquility." Rather, hedge funds and other speculators have been forced to cough up dollars to cover margin calls and to pay off creditors who've suddenly become wary of high finance shenanigans like the carry trade. Thus, they have had to call in their chips from abroad. In time, the structural weaknesses of the United States and its dollar will inevitably return:
Unless you are a speculator, this development is a good one. The yen has been wildly distorted by the dastardly carry trade for so long. The Japanese macro picture never justified such a weak yen priced in the 118-121 range. May it head below 110. Sorry, you carry trading speculators and hedge funds. You've had your fun, but this party looks like it's over.