Since the broad sell off in risk-related assets back in July and August of last year, caution has dominated the market’s taste for risk. The change in sentiment has increased the danger of holding carry trades which rely on low volatility and steady infusions of capital into the financial markets to prevent dramatic fluctuations in the spot rates of currency pairs that lead to capital losses. Now at the start of a new trading week, it is hard to refute the pervasiveness of risk aversion.
In equities, panic selling steeped the world’s benchmark indexes into remarkable declines. Starting in Asia, the Nikkei fell 3.9 percent as Friday’s late sell off in US markets produced an echo in eastern markets. However, as European markets came online, it was clear that Monday’s jump in volatility would be more intense than a mere sympathy move. The region’s financial centers all marked dramatic losses: the FTSE 100 fell 5.5 percent; the French CAC 40 tumbled 6.8 percent; and the German DAX Index plummeted 7.2 percent. For the carry trade, this has meant severe losses for the yen crosses, and indeed large declines for all pairs that have carry-related interest. With today’s jump in volatility, the carry trade has established a 10.6 percent draw down – the worst since May of 2006, and nearly a record.
And, while a low seems to have been set for the carry trade with the Asian and European markets’ close, a new record may be just around the corner. In Monday’s global selloff there was a notable absence from the US. The Martin Luther King holiday has delayed the American market’s reaction to the worst equity selloff since September of 2002. However, it was clear from price action in the futures markets that tomorrow’s open would see the US market playing catch up to the sharp losses. In holiday trading, the active Dow Index futures contract dove 514 points or 4.25 percent. With fears of an imminent US recession, worsening credit markets and a potentially volatile FOMC rate decision next week weighing on investors; it looks as if conditions for the carry trade will only worsen before they get any better.
Despite the recent injections of liquidity by the world’s most important central banks, the global financial system remains vulnerable and the outlook for carry trade is still very bearish. Last week, the DailyFX Dynamic Carry Trade Portfolio was down by 854pips. The most unprofitable trade was the position we held in the New Zealand dollar with 411 pips gain in capital losses offset by $39 on interest payments accumulated along the last 5 days. Looking ahead, the Federal Reserve is expected to cut the Fed Funds rate by 50 bps when the FOMC holds its next meeting in January 30, 2008. According to futures trading on the Fed Funds rate, traders are fully pricing a 50 bps rate cut and as much as 46 percent probability of a 75 bps rate cut to 3.75 percent. The rate cut is likely trigger a major recovery in the U.S. stock market and help all classes of risky assets, including carry trades.
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What Are We Currently Long?
NZD/USD
AUD/USD
GBP/USD
Additional Information
Making profitable carry trades are not as easy as they use to be. Therefore we have created a dynamic carry basket that changes when the monetary policy outlook for a central bank changes or if there is significant event risk ahead. Follow the performance of the DailyFX Dynamic Carry Trade Basket
What is Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Money shifts from around the world in seek of the highest yield and the benefit of trading currencies is that you are dealing with countries that have interest rates, which are charged or received every single day. If you are positioned on the side of positive carry, you have the right to earn that interest, which can be quite lucrative over time.
Protective Stop-Loss
Substantial gains made from interest rate differentials provide undeniable evidence that the carry trade strategy has been very successful over the past few years. Still, this strategy involves significant risks and an adequate protective stop is required. We are using a protective stop-loss equivalent to five times the average true range. Stop losses are activated when we have a weekly close below the specified stop level.
Position Sizing
Our position size varies according to each currency volatility. Generally, the more volatile the currency is, the fewer lots we trade. For example, let’s assume you have $10,000 and you are trading 10K lots, you decide to limit your risk per trade to 3% or $300 and the 90 days average true range for the EURUSD is 100 pips. In this case, if you go long EUR/USD you could buy 3 lots, since ($10000 * 3%) divided by (0.0100*10K) = 3 lots. In case the final result is not an integer you should always rounded it down to limit your exposure.
[I]Written By: Antonio Sousa and John Kicklighter, Currency Analysts for DailyFX.com
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Contact Antonio or John about this article at <[email protected]> or <[email protected]>