Market Highlights
- Equities Rise
- Currency Volumes Low
- Of Nickels and Steamrollers
Equities Rise
Markets worldwide rose modestly over the trading cycle in response to strong earnings reports and a rise in European economic confidence. Consumer goods companies such as Dell and L’Oreal reported revenue increases, supporting optimism for a resurgence in consumption. First-time unemployment claims in the U.S. dropped slightly to 570,000, below their peak of 600,000 earlier this year. Hong Kong and Shanghai shares dropped sharply, reacting to reports of reduced lending by Chinese banks. Futures indicated a strong opening for U.S. equities, suggesting that there may be a brief rally early in the morning, losing momentum towards midday.
Currency Volumes Low
Thin trading generally prevailed in the currency markets, with the euro and sterling both up in choppy price action. The Japanese yen gave up some ground as investors sought risk assets. The Aussie and Kiwi both rose slightly, but failed to break technical resistance barriers to move higher.
Crude oil moved up, trading over $73, and Nymex Henry Hub natural gas broke the $3 barrier in a late-day rally. The Canadian dollar moved up substantially, landing near the zenith of its recent trading range in the low-1.0800 area on the back of commodity price increases. Prime Minister Stephen Harper pledged to balance the budget once the recession ends without resorting to tax increases. Going into next week, traders will again be looking for any reduction in economic growth expectations, leaving commodity prices and the CAD exposed to a price correction.
Going into a late summer weekend, trading will be choppy and volumes will be relatively low today. Taking advantage of wider price action earlier in the day is recommended, as liquidity conditions will likely thin out further in the afternoon.
Of Nickels and Steamrollers
One of the most profitable and important trading strategies over the last few years has become known as the carry trade. Essentially a mechanism for taking advantage of interest rate differentials between countries, it has become one of the most important drivers of currency flows around the world. Everyone from Wall Street financiers to Japanese housewives are in on the game, borrowing money at ultra-low rates in Japan and reinvesting in high-interest rate environments like Australia. The massive size of these flows has a substantial effect on foreign exchange markets, depressing some currencies, causing others to appreciate, and raising exchange rate volatility worldwide.
An investor in a carry trade effectively borrows in a low-interest currency and lends in a high-interest currency. Assuming that exchange rates do not move negatively over the duration of the trade, the investor is then able to sell the high-yielding currency, use the proceeds to pay the loan in the low interest currency, and pocket the interest rate difference.
According to textbook economic theory, the carry trade should not work. Countries are able to keep interest rates low because they are considered to be low-risk jurisdictions, with strong and stable currencies. Other countries must keep rates high in order to attract foreign capital because they are considered to be at greater risk of default, and more likely to have depreciating currencies over the long run. Indeed, in many cases this has been proven correct—Iceland’s economic collapse last year wiped out many investors who had accepted higher risk in return for higher yields.
In practice, this trade is generally conducted with high levels of leverage—traders often control between ten and 200 times their original principal, allowing for substantial returns, but setting the stage for catastrophic losses. This type of trading strategy has often been characterized as “picking up nickels in front of a steam roller,” meaning that many small gains are eventually wiped out in one big loss.
Over the last decade, large disparities in interest rates around the world, even among developed economies, made the carry trade tremendously profitable. The difference between low yen and high Aussie interest rates made this the most common carry trade, but many other currencies exhibited large differences as well. However, in the last year, a seismic shift has occurred as interest rates around the world have been driven down in an effort to stimulate economic growth. In nominal terms, interest rate yields between currencies have fallen to minimum levels, leading many commentators to declare the carry trade dead.
However, two factors are pointing to a revival of the trade, albeit at lower levels. First, deflation is occurring in several major economies, meaning that currency borrowed in yen can be invested in U.S. Treasuries, earning effective yields several percentage points above zero. Second, investors are inverting the ancient banking strategy known as “borrowing short and lending long.” Investors today are borrowing for the long term at low rates and are lending short term in the hopes that interest rates in the invested currency will increase enough over time to turn a profit. On the surface, this appears to be a good strategy—interest rates really are likely to rise. But unpredictable exchange rate fluctuations have the capability to wipe these gains out in short order.
The return of the carry trade has many implications for currency flows around the world, and the effects are already being felt. When the terms “risk acceptance” or “risk aversion” are used to describe the rationale for currency moves, it is often a carry trade that is being described. Investors are either seeing an opportunity to make money on differences between risk environments, or their investments have suddenly become dangerous and they are heading for the exits. For currency market participants this is actually a wonderful thing—volatility provides opportunities for profits. But it is a force to be aware of.
For carry trade investors, it would be wise to keep well ahead of the steamroller, and for commercial traders it would be wise to keep well ahead of investors running from steamrollers.
Have a great weekend!
By Karl Schamotta, Market Analyst
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