Hello John,

Just found this thread and it's a very informative read. I'm a beginner when it comes to fundamentals and would really like to understand more about this area, in particular by use of an example so as to consolidate my knowledge and understanding.

AUD/CHF is currently trading at approx. 0.9100. This currency pair is obviously a candidate for the carry trade with a high yielding currency against a low yielding one. However, looking at the projections for the interest rates for the two countries over the medium term (say a year out), the expectation is for the Aussie interest rates to continue to be cut whereas the Swiss is expected to be stable (or possibly upwards next year).

Based upon a falling interest rate and a stable to rising one, am I right in saying one would expect the Aussie dollar to weaken against the swiss and start moving downwards, say towards a .8500 exchange rate? Therefore, the carry-trade involvement would start to be unwound between the 2 currencies.

However, I read that the Aussie is strongly correlated with the commodities, particularly gold. Gold over the past week has been making some very strong up moves and could be resuming it's longer term up trend thus if the correlation remains this would give strength to the Aussie dollar rather than the weakness I describe above. How does one interpret these apparent conflicts in the Aussie dollar v ths Swiss Franc and come up with projections as to where a currency is likely to head, based upon a fundamental stand-point?

Where is the AUD/CHF pair likely to be trading in saying 3-6 months and a year out given the above apparent conflicting scenarios?

Hello Freefox,

Good questions.

The medium term interest rate outlook (which most industrialized central banks target) for both central banks is indeed matching your suggestions. The RBA is expected to shave another 100 basis points off its benchmark and the SNB is expected to keep its target range unchanged through the coming year.

Everything else being equal, we would expect these rate forecast to lead to the Australian dollar depreciating against the franc. However, this isn't an 'everything else being equal' world; so we need to factor in what a fair value for this exchange rate would be before rates were adjusted and after they were adjusted to reflect expectations. Even if the RBA does cut a whole percentage point off its benchmark, it would still be well above the Swiss figure; so there is going to be a point where it comes to equilibrium.

As for introducing commodity prices, that is another, unique pricing dynamic (there are thousands if not millions of different fundamental factors to take into account). Commodities are an important driver for the Australian dollar because the country is one of the largest producers of coal, gold, cattle and many other natural resources; and when you buy those goods from them, you first need to exchange your currency.

However, the correlation holds more closely to those pairs that include major consumers and producers of said commodities. That's why AUDUSD holds such a correlation thanks with the US representing the largest consumer of natural resources. For AUDCHF, that correlation is much weaker.

You definitely need to determine the influence each factor will have on currency pair. AUDCHF is primarily guided by rate expectations - by a wide margin. However, there is still a correlation to commodities; but that is because there is more of a speculation component to commodities as well - as traders use some goods like gold to hedge interest rates and growth.

All that being said, I wouldn't suggest anyone trade a carry in one pair. The leverage could easily force a margin call as capital gains and losses are far greater than any daily carry. Instead, one needs to be diversified in at least 4 (that is a number we have found does most of the diversification) carry trade pairs. But even then, you still have a discretionary call on risk appetite.

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com

Hi, I've noticed that over the last several days, FXCM has appeared to drastically reduce the amount of carry trade interest it's paying on NZDJPY. It was about $1.40 plus or minus and couple cents per mini-lot per day for a long time, but recently, there have been some days where it pays $0.00, $1.00, or like today, $0.20. I haven't noticed anything like that with the other pairs...

What's going on?

It is going on with other pairs, but to less of an extent.

FXCM has a no dealing desk structure, so all orders are passed on to the intermarket to be executed against opposing orders (as opposed to a dealing desk where the broker will take the other side of your position and hedge it on their own terms).

Recently, their has been a crack down on speculation where central banks have temporarily raised overnight lending lending rates for those looking to borrow funds and lowered the return that can be received for providing those funds (this pans out to be a similar type of action as enacting the short sale ban on financial stocks on the same day the market was preparing for the quadruple witching hour). So, rolls are tightened as a natural reflection of market difficulties (rates have also been boosted by the natural glut of demand).

It was far worst last week, when panic was fully set in. Today things are much better compared to last week. However, there is still an issue with those pairs that have greater risk. NZDJPY is relatively illiquid and it has a very wide yield differential, so the effects of the higher lending rates will linger a little longer than those that are more actively traded.

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com

Thanks John, I apreciate your time and effort in explain that.

Thanks for that John.

I understand what you mean about the competing fundamentals and the need to somehow quantify the influence each factor will have on the currency pair to determine future projections. I imagine this is where fundamental analysis gets very complicated and hence why there can be differing views as to just what the impact a particular element has.

You mention everything else being equal that a 1% cut by the RBA would lead to the Aussie dollar depreciating against the Franc. I can see that on a carry-trade, with a 100,000 CHF position this would lead to a loss in the interest amount acrued of 1,000 CHF over the course of the year if it was held as Australian dollars. Is my thinking and logic correct here? I know on its own this would be a silly thing to do as it doesn't take into account any capital depreciation, but I'm highlighting it purely as an exercise to understand the mechanics of the carry-trade.

On a further point if my math is correct above, is there a calculation/model that can be applied thats says that for a 1% interest rate cut in one currency (AUD), it can forecast what the exchange deprecation against another currency (CHF) would be? You mentioned about deteriming the influence of each factor and was wondering if that such a model existed to quantify interest rate movements between currencies or are things not as simple as that?

Thanks once again. I do appreciate your time reporting on this thread.

Perhaps if you were working with neural networks or something else that can process many different variable at once, you could perhaps get a good forecast for price action (if we could, it would certainly be exploited by banks and traders to the point that it wouldn't work anymore).

The problem here is that the response in price isn't necessarily to the rate hikes or cuts, but speculation of rate hikes and cuts over time.

You also have to consider that these are benchmark lending rates we are talking about. Banks aren't even able to access these optimal lending rates (except for those large lenders that deal with the central banks). Big banks lend to each other at the overnight Libor rate. Regular retail traders have access to a rate that is well above the Libor rate as their credit worthiness is much lower. So you end up getting a much lower rate than 7.00 percent holding the Aussie and have to pay much worse than 2.75 percent for borrowing francs.

Then, there is still the issue that there are other market dynamics to take into account for fundamental price action.

So, while we could theoretically measure the impact this shift in rates could have on price action in a vacuum; in the real world its impossible. Therefore, its best just to approximate. Of course, since price adjusts on rate expectations rather than the actual hike or cut itself (unless there is a surprise), it requires you to be on top of things and take some discretion of your own - (are these expectations reasonable and while they grow more or less aggressive with time?).

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com

hey, my name is mike. I come from Guangzhou China. I like to browse the thread through i can understand completely.
I like making friends with you if you don't mind.
Best Regards! Have a good day!
mike mike@phohp.com QQ:597906556

John,

Very interesting to see what has happened with the AUD/CHF pair since your last reply to my questions. On 23rd September it was trading at 0.91 and now it's touched 0.73; a 20% depreciation in 2 weeks!! Historically has there been any move has big as this in such a short period of time and can it really continue downwards at such a rate?

You mentioned, that "price adjusts on rate expectations .. (unless there is a surprise)". Well we got the surprise earlier in the week when RBA surprised the market and agressively cut interest rates by 1%.

This 1% cut must be a factor in the continueing decline of AUD/CHF but are we also witnessing here the "death of the carry trade" in general?

Due to the financial turbulence across the world and the deleveraging of assets are people moving out of high risk assets/strategies? There is talk of coordinated interest rate cuts across the markets which may give the AUD/CHF, and others a large reactionary bounce. Will these be enough to stabilise the markets and lead to more of an appetite for risk and thus give life back to the carry trade or can we say that 2008 has seen the end of the carry trade?

Interested in yours and anybody elses views on this?

Hello Freefox,

There have been record breaking moves in a number of pairs - and most of them have involved either the Japanese yen, Australian dollar or New Zealand dollar.

The RBA's decision to cut rates by a massive 100 basis points certainly had a hand in the AUDCHF's decline, but from the reaction to the rate decision in AUDUSD, you can see that the market was largely pricing in a large rate cut ahead of time. Instead, you are looking at the suffering of a carry trade pair that has one of the highest returns (and thereby the greatest risk). The meteoric rise in fear over the past few days has more to do with this pair's decline, though a cut to the possible returns of a carry trade play a party in its appeal.

As you can probably see by now, the coordinated rate cut certainly didn't lead to an instant rebound in confidence (we could see it return slowly). On one level this may help to insure the global policy makers are ready to make the effort to stabilize the market, but it also suggests they think things are bad enough that such a move is necessary. What's more, from a carry stand point, the general returns from yield differential took a big hit with this coordinated rate cut; and when the strategy hangs on a delicate balance of perceived risk and potential returns, a drop in yield clearly tips the scales.

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com

"While volatility surged across the markets after the US House of Representatives shot down the first vote on the $700 billion bailout plan this past Monday, the successful second attempt on Friday found a far more muted response. Looking beyond the short-term implications of this immediate event risk, risk appetite continues to plunge. Over the past week, the DailyFX Carry Trade Index plunged 1,056 points to 25,429. While there is some precedence for support back in June of 2006, the popular strategy has notably tested lows this week not seen since January of 2005. What’s more, taking a closer look at market condition indicators, it seems that fears are growing rather despite policy makers’ efforts to revive confidence in the credit market. The DailyFX Volatility Index has surged to new highs above 14 percent – levels not seen in over 10 years. What’s more, risk reversals show options traders continue to bid up protective puts as the declines in yen crosses and other popular carry-pairs gain momentum."

Hey John,
I found this in one of your recent posts on the carry trade environment, from quite recently.

I have been hearing a lot about volatility indexes recently, what does the volatility index mean to you, is it supposed to signal a reversal when it is very high?

Bertie

Hello Bertie,

Like most, I believe that volatility is a mean-reverting market condition. Market activity can't remain extremely high or low (unless that is the nature of the asset like natural gas or treasuries) for very long. For the currency market, there is far too much liquidity and it holds a much greater economic use than other financial assets to remain excessively volatile.

So, I would say when we hit an extreme, the markets will go back to normal - calmer. Of course, just as it is with any indicator, it is hard to define an extreme. We haven't seen this much volatility since at least 1998; but fundamental conditions are as bad as they were during the Great Depression. As such, it is possible that fear could hit the next gear - though much further would likely mean a major economy is about to fail.

As you can see from our Volatility Index below, markets are already cooling off - though they are still near historical highs.

Three to six months down the line, we could very well be in another trough for price action.

Attached Images

 

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com

[quote=John Kicklighter;196772]Hello Bertie,

Thanks for the response John. So like any indicator, it can prove very useful, and even more useful in hindsight!?

So coming onto the recent levels of volatility, what pair would you be looking to use for a carry trade, the classics like GBP/YEN? Are there any specific indicators that you will be looking for, both technical and fundamental?

Well considering that the GBPJPY just broke 170 and is now trading at 167.83, I'd have to say that I would abandon this strategy.

That's just me.

I agree with Karen. I wouldn't trade any pair for a carry right now.

Realistically, in the best of times you would only make 15 perhaps 16 pips worth of roll on GBPJPY. What's the average range of this pair even in calm markets? Certainly not worth it. You need to diversify for the carry trade for it to actually work over time.

In these markets though, you simply cannot use a carry trade. Overnight lending rates are oppressive, so you won't get a good roll in the market. What's more, volatility still points to huge capital loss potential.

Right now, I'm just watching carry as a barometer for risk in the currency market. Not going to even consider this a trading opportunity for a long while.

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John Kicklighter is the author of Dynamic Carry Trade Basket, Watch What The Fed Watches, and Forex Trading Weekly Forecast on DailyFX.com