Sat 4 Aug 2007
If I Hear The Carry Is Dead One More Time…
Posted by Quicksilver under Commentary , Uberman's PortfolioNo Comments
You can’t click on a link on the net today, it seems, without coming across someone talking about the unraveling of the carry trade. Will the Japanese raise rates and end the party? Everyone knows that the ZIRP (zero-interest rate policy) of Japan is a major spark for carry trades since to have a carry you need one higher interest rate and one lower one to make it work. And zero is pretty low.
Everytime I hear?about it, I want to throw something. First of all, it’s a matter of principle.?When the media talks about the “carry” they almost always mean a trade involving the JPY and mainly something like the NZD/JPY or CAD/JPY since these are some of the largest spreads in interest?rates available. But technically a carry trade always exists somewhere, except for the day when we might all go to a universal currency (gasp!) or all interest rates are the same (which has never happened).
The only thing that might go away is the sweet Japan deal. But, people, calm down. The spread between the JPY and?the?AUD & CAD is 5.2%, the GBP 4.9% and the USD 4.125%. And the NZD/JPY? Try 7.2%. Japan would have to move up a great deal before these became “dead”. Other spreads that don’t even involve the JPY included some at 2.9% (GBP/CHF), 2.4% (NZD/USD), 2.1% (USD/CHF)?etc. and these have noticeably lower volatilities. And these are only the spreads that are directly tradeable. You can simulate any spread with multiple positions. The spread between the NZD and the CHF is 4.5% nearly matching that of the famed top JPY spreads!
Also, what I can’t seem to understand (will I ever understand the media) is why everyone is so worried about Japan raising rates but no one seems to have notice that so is everyone else. It takes two to tango and the JPY isn’t the only factor in a profitable carry trade equation. It’s basic math. If one interest rate goes up and so does the other by an equal or greater amount, then what are you left with? A carry trade that is of equal or great worth than it was before. As of their last interest rate change,?8 of 10 of the “big” currencies have increased the interest rate spread against the JPY despite the Japanese increasing their own. And back in a 2002 (when Oanda started posting tradable interest rates), best spread against the yen was barely above 4%. No one was calling it dead then. Well, who am I kidding. They probably were. The point is that until the return/risk ratio drops to a point that makes trading the carry less attractive than some other investment, it’s not dead. It is stronger than ever despite what fear my strike it. It’s just that: fear. I think this points out the inherent problem with listening to pundits without making your own assessment of value. The same is happening right now in the stock market.
But I have a theory. As long as an investment has inherent value, the collective behavior of traders, no matter how one sided the strategy of any one,?will eventually find it and will act has one large “super-investor” trading an optimal portfolio. And since an optimal portfolio can be found in FOREX that produces a healthy interest rate, the “super-investor” is best served by being long the carry trade for now and ignoring the death knolls.