What is a carry trade?
In finance, the carry of an asset is the return generated from holding an asset. A carry trade typically involves buying a currency and carrying or holding an asset until achieving a profit.
Carry trade is a two-part trade that involves buying a high-yielding currency and funding with a low-yielding currency. It resembles the equity trading strategy of buying low and selling high. In addition to accruing interests, it seeks to capture the spread or the interest rate differential between the two currencies. By utilizing leverage, it hopes to magnify the returns.
Why is the carry trade so popular with forex traders?
The carry trade has been around since the 1980s. Only in recent years have it become popular with the press, media, and individual investors.
Carry trades can be risky since it is highly leveraged. However, it remains one of the more popular and profitable strategies in forex trading. The carry trade attracts many forex traders when the central banks are either raising interest rates or sending out messages that they intend to raise rates.
Traders often focus their carry trades on high-yielding currencies in secured and lower-risk countries. The more popular carry trades include historically favorite currency pairs such as the Australian dollar/Japanese yen, New Zealand dollar/Japanese yen, and the US dollar/Japanese yen.
What is a positive and negative carry trade?
A positive carry trade is a conventional forex trade that involves buying (carry current) and borrowing (funding currency) to implement a high-interest versus low-interest rate pairs trade. Two popular positive currency carry trading strategies are AUD/JPY and NZD/JPY. The trader typically borrows Japanese Yen and buys the Australian dollar or the New Zealand dollar.
A negative carry trade is less conventional and involves buying (carry current) and borrowing (funding currency) with the objective of a low-interest rate versus high-interest rate trade. The strategy involves borrowing a higher-interest currency and buying a low-interest currency with the expectation that the currency with the lower rate will appreciate relative to the one with the higher interest rate.
Return of the Japanese Yen carry trade?
The popularity and profitability of the FX carry trade declined soon after the Global Financial Crisis/Great Recession as global central banks dramatically eased their respective monetary policies, driving interest rates to near zero. In some countries slipped toward negative rates. However, as inflation climbed to multi-year highs, central banks began reversed monetary policies by hiking interest rates.
Will the carry trade strategy return to favor as the gap between the US dollar and the Japanese yen widen considerably, providing a positive carry trade leveraged opportunity?
In December 2022, volatility exploded overnight after the Bank of Japan (BOJ) unexpectedly widened its target range for the 10-year Japanese Government Bond yields to fight inflationary pressures. It sparked a sell-off in bonds and stocks around the world. Today, BOJ again surprised traders when they decided to maintain its ultra-loose monetary policy to keep its yield curve control targets unchanged at -0.1% and the 10-year Japanese Government Bonds (JGB) yield at 0%.
Bank of Japan's ultra-dovish policy moves to stimulate the Japanese economy surprised but also unnerved global investors. The yen abruptly fell against the USD, declining more than 2% during the afternoon before paring losses by the end of the day. The bond market also experienced increased volatility as BOJ defended its yield cap by buying many of its 10-year government bonds.
Although the Japanese yen remains a favored safe-haven and funding currency, the US economy continues to lose momentum, evidenced by the report of weak US retail sales today, posting one of its sharpest declines in the past year.
It is now critical to monitor the price actions in the USDJPY as it nears pivotal support. A daily death cross-sells signal as the 50-day ma (135.79) recently crossed below the 200-day ma (136.62), and a head and shoulders top warns of a USDJPY top.
The 20 and 30-year breakouts during 2022 above 147.62 (Aug 1998 high) rendered targets to 151.77-152.62 (Mar 2022 breakout target and Jun 1989 high) and 160.35 (Apr 1990 high).
USDJPY rallied sharply to 151.95 (Oct 2022), achieving its price objective. An overbought condition accompanied by a negative outside day on 10/21/22 prompted a consolidation. The decline has been sharp as key supports broke, including 138-139 (8/29/22 gap-up, 9/1/22 breakout, and Nov 2022 lows) and below this 136-137 (10-mo, 50-day, and 200-day ma, achieved), 133 (38.2% retracement from 2020-2022 rally, achieved), 130-131 (Jun 2022 breakout and the Aug 2022 lows, achieved), and 125-127 (Apr 2022 breakout, May 2022 lows, 2015 highs, and the 50% retracement).
Violation here confirms a large head and shoulders top breakdown. A subsequent decline below 124 (top of the 2021 uptrend channel) and 121.5-122.5 (61.8% retracement and the Jan 2021 uptrend) reaffirms a major USDJPY top.
Initial resistance falls to 132-133 (Oct/Nov 2022 downtrend) and above this 136-137 (38.2% retracement from Oct 2022-Jan 2023 decline, 10-mo, 50-day, and 200-day ma), 138-139.5 (50% retracement, and the July and Dec 2022 highs), and 142.25-145 (61.8% retracement, 11/10/22 breakdown, and 11/21/22 high). Above this hints at a rally toward 151.95 (Oct 2022 reaction high).