Unbiased Forex Broker Experts

Part II. Should We Rely on Carry Solely?

Should We Rely on Carry Solely? - Forex School
Pipruit: Sir, I suggest that we’ve discussed mostly the technical foundation of the carry trade, but what about analysis? Is it just a technical feature and we should not pay much attention to it, or carry makes some sense and it’s worthy to be used in some economic conditions. The only question is what conditions…​

Technical foundation of the carry trade - Forex School
Commander in Pips: Yes, we have to speak about it. The first thing, and most simple one, that could form your relation with carry is what kind of trader you are. I think that you understand – taking into consideration carry on a 5-min chart trading is absurd, 15-min – absurd, even 4-hour trades. But, at what time frame does trading carry makes sense? Surface answer is – when it becomes a valuable part of your total profit or loss, and this makes us think that we speak mostly about trading on weekly and monthly charts, i.e. long-term traders - but not only about them… This could even be even day traders, if they use significant leverage. Carry trade could be more significant for a day trader, who holds position for 1 week at 1:100 leverage than for weekly trader who holds position, say 3 months but just at 1:3 leverage. Do you understand me?

Pipruit: Not quite. Your statement is a bit blurry.

Commander in Pips: Ok, here is easy example. Let it be the same AUD/USD. For simplicity we assume that rate at open date was 1.0 as on the close date. Let’s assume initial margin with the position is 5K USD. Then, day trader position will be 5000*100 = 500,000 USD at 4.25% annually of carry. While weekly trader position will be just 5000*3 = 15,000 USD. The first trader holds is for 7 days and earns: 500,000*4.25%*7/365 = 407.53$, while second trader holds it 3 months: 15000*4.25%/4 = 159.37 USD. See – depending on margin, carry could give more significant impact on one account, at the same term of position holding.

Pipruit: Oh, I see.​

Commander in Pips: But anyway this should be relatively medium term trade with average leverage to treat carry impact as valuable. So, initially you have to make such kind of calculations and then decide – to be worry with carry or not to be…This is first.

Pipruit: Second….​

Commander in Pips: Since we’ve just estimated that carry value is important mostly for long term trades, this forces us to dive into the Fundamental analysis pool, since long-term trends are driven mostly by fundamental factors.

Pipruit: How does it deal with carry?
Commander in Pips: What is a carry? In fact, this is a rate difference. Hence it depends on the interest rate in each country. For you it will be most important rates in countries of particular pair, say AUD/USD. As we’ve discussed earlier, rates could be increased or decreased by central bank in different economic environments. But this is only half of the puzzle. The second half is the overall condition of the world economy. In fact possessing on the carry is a question of economic cycles.

Commander in Pips: The point is that forex speculators (both long-term as short term) want just make money on rate difference, and if they will be able to surplus some carry – all the better. But there are a lot of other participants, big financial institutions, hedge and mutual funds who use carry in a bit different way. Their forex position is just a sub product of total investing. Their major aim is to earn a return on their investments that they did in bonds, shares, commodities, futures etc. So, they use forex just to convert a weak currency into strong currency. Then they invest the strong currency in some assets that let them earn a greater return than just the central bank rate.

For instance, some hedge fund borrows JPY, sell them for AUD and invests the AUD in Australian government and corporate bonds and shares. In this case, this fund pays a bit larger than 0.1% rate on JPY loan, but it earns much greater than just 4.5% (AUD rate).

Pipruit: But what if the AUD/JPY will start to rise? This fund will have to pay out more JPY, so its real rate will increase significantly…​

Commander in Pips: You’re looking right it the root of the issue, but why should the AUD/JPY should start to rise? What are the reasons? You should understand that now we speak about changing of fundamental trend – short-term splashes and other noise do not interest us.

Pipruit: Well, I don’t know, what if crisis starts, as in 2008, or the Australian economy will fall in recession?​

Commander in Pips: That’s it! You answered your own question, when it makes sense to deal with carry by yourself.

Pipruit: I did?​

Commander in Pips: Sure. Since carry is a feature of long-term positions, you have to be sure, that there will not be any problem with economy that you invest in - no matter what you’re doing – buying currency (long in AUD/USD of AUD/JPY), Australian bonds or shares – anything. You must have confidence that the Australian economy has a nice pace of growth, probably central bank even increasing the rate again, so carry will become even bigger. That is a question of fundamental analysis. At the same reasons you open AUD/JPY position on a monthly chart. In other words, you should have confidence about perspectives of the Australian economy for the term of your investment horizon. In this case any fund will not just succeed in real investments in bonds and shares; it also will get huge positive carry, and, probably rate appreciation. So, good perspectives on the economy are some kind of insurance that your carry will have significant additional profit on long-term forex pair position and not a shallow compensation of loss or drawdown.

This usually happens when business cycles turn to a growth phase after recession. Better to anticipate increasing of carry at the early growth stage that is called the “disinflation stage”. At this stage inflation is low and markets are only starting to rise. Since the central bank has not started rate increasing yet, carry could be not so impressive. The second growth stage is “inflationary” that is typical for an overheating economy. At this stage the central bank starts to increase rates to control inflation, while the economy still continues to growth but at lower pace. This stage gradually turns to stagflation and then again to recession, when central bank starts to decrease rates, since growth becomes anemic and inflation turns to decreasing.

Pipruit: And what about world economy, second part in our discussion…​

Commander in Pips: If the cycle changes in the world economy, say to recession and crisis as in 2008-2011, then investing in particular countries, even if they have solid interest rate, will not help you. The point is risk aversion. In such circumstances, investors think about how to keep their money safe but not how to get more return on it. Let’s suppose that you have some significant amount of money and Ben Bernanke will tell you: hey pal, there will be a crisis soon, unemployment will rise to 25%. What you will do? Hardly you will invest your money in some Brazilian bonds at 40% annually. You understand, that this money is all that you have. May be you will lose your job, and they will become the single source of funds for you to live. That’s why in such circumstances all market participants want to find a safe-haven to save their money but not earn great return on them.

Pipruit: And what is a safe-haven?​

Commander in Pips: Traditionally they are – gold, US Treasuries notes and bonds, US dollars, JPY, CHF, Swiss bonds. But with the current crisis many traders are starting to reassess this traditional view, especially on USD and US bonds. But this is not the topic of our current discussion.

Pipruit: And what’s next?​

Commander in Pips: Very simple. Let’s assume that you’ve analyzed the perspective of Australia – low budget deficit, high rates, stable growth, average inflation – in other words, good perspectives and a high 4.5% exchange rate. But a month later, the world economy falls into crisis, like in 2008. Despite the fact, that Australia will not decrease its interest rate and rate difference to JPY will remain the same, as with USD – you will lose money. Since traders will start to invest in safe havens – USD, JPY and CHF. To invest, they need these currencies first, and your AUD/USD will turn south.

Pipruit: Wow, cool. Ok, looks like I understand of foundation of carry stuff:

1. Forex carry, in fact, is a byproduct of long-term position;

2. Carry itself can’t save your long-term position, if you were wrong on the perspective of some economy that you’ve invested in by purchasing its currency, say AUD;

3. To make carry a valuable add-on we need low risk aversion among world investment society on the world economy – major world economies should turn to growth cycle stage. Under these conditions carry gradually increases the pace;

4. If the world's economy feels good, then you must be sure that particular economy also feels good. Sometimes, they could feel different. For example, compare the US economy and Japan's economy. The US has passed through many cycles, while Japan stands in long stagnation;

5. When risk aversion is high, and typically this happens during strong recessions – investors start to search for safe-havens to save their money. This leads to closing of carry positions. In this case, even if AUD/USD shows an attractive rate difference, investors will continue to buy USD and decreasing of AUD/USD highly overruns the positive carry.
Commander in Pips: Yes, you’ve said it correctly. This easily could be compared with a human being. When you’re starving (crisis, high risk aversion), you can’t think about anything else than just to eat (safe money). But compare that to when you’re full – you have good mood, and ready to have fun and make a party. The same is with investors – when the economy feels good and all things are growing, investors risk appetite also increases and they want some piquant and exotic return – they dive into carry and start to invest to emerging countries and developed countries with higher interest rates, i.e. with positive carry.

Pipruit: Nice comparison, thanks. In other words, if perspectives of the economy are good, and they will appear to be so – carry will add more return. If not –carry will not help you.​

Carry tuning

Commander in Pips: Since we have finished with discussion of foundations of carry, let’s speak about parameters – what currencies to choose for carry and what the risk of carry is.

At the first question we’ve answered already:

1. We need as greater interest rate difference as possible, but at the same level of credit risk. I mean, probably you may find some currency, say the Russian Ruble that has 8.5% interest rate, but Russia’s credit rating is BBB+ while US rating is AA+ (almost AAA), so this difference comes from credit risk also. That’s why when we’ve said “greatest rate difference” we mean among comparable currencies in terms of credit risk – major currencies.

2. We need for fundamental perspectives stay positive for a significant period of time.

3. The currency pair should stay in the range or show some move in a favor of a higher rate currency.

Here is a chart of AUD/JPY from 2002:

Chart #1 | AUD/JPY monthly
Carry tuning - Forex School
Impressive, right? While Australia has passed through some world cycles during this period, Japan economy remains weak, since it has entered long recession and stagnation right from 1990s. So, Japans rates were at lowest levels around 0.1%. This was a really good possibility for carry…

Now about risk aversion:

Chart #2 | AUD/JPY monthly
AUD/JPY monthly-Risk aversion - Forex School

In 2008, the world economic crisis has come and caused a jump in risk aversion. Despite the fact that the AUD and JPY rate difference remains significant, high demand for safe haven JPY broke the previous long-term tendency. But in 2009 you can see that some kind of positive carry has been reestablished.

Also the great example of risk aversion you may find on USD/CHF pair from 2008. Although rate difference is quite shallow, CHF has shown outstanding growth, since this is a safe haven currency.

Risk of carry

For forex traders risk controlling procedure is almost the same as for any trade – you want to exit when it appears that your view has become wrong. The major difference is just in scale. Since positions that usually being opened for carry is long term, the stop loss orders also will be farther and risk in terms of pips will be greater. Long-term investment suggests earnings from a long term move. At the first view, this move looks outstanding – 4.5K pips on AUD/USD for 5 years. When you will divide it on time you’ll get 900 pips per year, but surplus farther stops and, as a consequence – lower margin that leads us to lower return in percents.

Don’t be deceived by absolute numbers. Since you invest long-term, your way of thought is in percents. Think in terms of return on investments – total assets, margin with potential stop loss. If you’ll get 15-20% annually on total assets during 5 years at small, say 1:5-1:10 leverage or even lower – this will be an excellent result, and carry will add significant amount of profit.

And the way to control risk is simple – logical stop-loss order. Logical means that it has to be placed in such place, that you will be 100% sure that you were wrong, if the market will hit it.

Comments

dkami
7 years ago,
Registered user
Thanks Sive for your lesson
So if I may ask whats your thoughts now in the current climate as we all know with this bubble emerging thanks to Ben bernanke and his printing press and all the troubles in the Euro Zone that's been going on for years now thanks to the willingness of the tax payers bailing out the banksters and the greatest short term risk being Israel and Iran on the verge of war over nuclear weapons not to mention unforeseen disasters like the tsunami in Japan is it wise to carry trade?
I see AUD/JPY on a monthly chart in a nice true range between 88.84(resistance) and 74.33(support) which is 1451pips is it wise to be carry trading these ranges? or wait until the bubble bursts and take out the support which could be tomorrow or next year or the year after that and start taking positions at next support 59.82 or wait for monthly candle break of resistance before taking longer term trades and taking profit at next resistance 103.35?

P.S.What ever happened to Giant2 did he go under with the tsunami because of over leveraging or is it just a extended holiday? LOL
But in all honesty I really hope he comes back as its one thing the FPA is missing carry trade guidance it a no brainer Swap + pip profit

Thanks again Sive for sharing
Sive Morten
7 years ago,
Registered user
> Thanks Sive for your lesson
So if I may ask whats your thoughts now in the current climate as we all know with this bubble emerging thanks to Ben bernanke and his printing press and all the troubles ..

Hi Dkami,
heh, pal, you've touched so sophisticated scenarios, so, I suppose that even Mr. Buffet will not answer. ;)
But, if you let me, I look at carry as long-term perspective, that is based on fundamental approach. Now I like Australia by it's rate, relation to gold and fundamentals (deficit, debt burden, budget income/interest payments etc). From that perspective Australia is one amongst the others (few) countries that gives nice real return on investments. US long time already gives negative real return.
You apply a bit different approach - combination of pure carry with technical analysis, so it's difficult to advise here. Anyway I will not be surprised if after some years safe haven role will drift in favor of AUD ...
One-fm
7 months ago,
Registered user
Thanks, Sive.

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