The Carry Trade: Get With It Or Get Run Over By It

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There has been a lot in the press over the past few years about the "carry trade" and most traders and investors don't give it much thought.

"That's some weird thing the hedge funds are doing," they think.  "It doesn't apply to me."  And that is where traders are wrong.

Dead wrong.

This is why most asset classes are selling off right now, and why they will continue to sell off for the next few months.  This includes assets like gold and silver.

How can this happen?

The carry trade impacts the markets today more than nearly anything else.  Stripping it down, it works like this:

Hedge funds borrow low interest currency like the Yen and US Dollars, and then put those funds into higher yielding currencies like the Australian Dollar.  Then they borrow against these Australian Dollars and buy appreciating assets such as stocks, gold, silver, grains, oil . . . you name it.

Why do they go to all of this trouble?

Simple.  To make big returns so they can collect big fees.

Why is this important?

Because when funds are “putting” on the carry trade, also known as "putting risk on," then most asset classes rise in value--the funds are buying them hand over fist.

More importantly, however, is when funds are "taking risk off."

When they do this, it means they are winding down portions of their carry trade.  To do this, they have to 1) Sell off the assets they bought, 2) Dump the high yielding currency they own and 3) Pay back the cheap currency they borrowed.  These three steps all happen very close to simultaneously.

Why is this important to know?

Because when hedge funds are taking risk off, nearly all asset classes will sell off, regardless of what's going on in the news.

That's great and all, but how would a trader know when hedge funds are putting risk on or when they are taking risk off?

By watching CNBC?

No.  They aren't really sure what happened until way after the fact.  If hedge funds could hide their footsteps and their actions, believe me, they would.  Surprisingly, this information on whether hedge funds are putting risk on or taking it off is very easy to obtain.  All you need is a data feed.

The AUDJPY cross is currently trading at 73.739.  This just means that 1 Australian Dollar is equal to 73.74 Japanese Yen.  Believe it or not, this chart represents what hedge funds are doing in real time.  The price of AUDJPY isn't critical.  What is critical is whether the chart is moving higher or lower.

It's not that AUDJPY represents all carry trade activity.  However, it does represent one very common carry trade, which is to borrow Japanese Yen and then put that money into Australian Dollars.  The more Yen that is being borrowed, the more the Australian Dollar is being bought, thus the higher AUDJPY goes (that is, as risk is being put on, one Australian Dollar can buy more and more Yen).  Thus, when the carry trade is "on" then AUDJPY will rise.  And when the carry trade is being taken off, AUDJPY will fall as Auzzie Dollars are sold to payback the Yen loans.  If that seems a little complicated, this is all you have to remember:

AUDJPY Moving Higher = Risk On = Assets Rise

AUDJPY Moving Lower = Risk Off = Assets Fall

The last reason it is important to understand the carry trade is because it explains what many people find unexplainable.

For example, during the 2008 financial crisis, everyone and their mother were talking about how the US Dollar was dead, and how it was critical to put all available funds into gold and gold stocks.

But what happened during the heat of the financial crisis in October 2008?

Gold got annihilated, selling off from $1080 an ounce down to $707 an ounce.  Gold stocks fared far worse.  Goldcorp Inc. (GG), a very solid and popular gold stock, fell from $52.65 to $13.84.  This was a typical move for gold stocks during the heat of the financial crisis from July to October 2008.  Everyone who thought they were smart and did "the wise thing" got taken out back and shot.

What happened?

AUDJPY shows exactly what happened…

During this time, risk was coming off in a big way, as AUDJPY plummeted from just over 100.00 to below 60.00.

Remember when I said markets move because they have to, not because they want to?

Bingo.  This was essentially the largest margin call in the world.  Funds were forced to sell everything that counted as an asset, and that included gold.  It didn't matter what the asset was or if it had intrinsic value or not.  All of the assets they bought with borrowed money had to be sold so they could pay back their loans.

And this is also why the US Dollar rallied during this time.  The US Dollar is also used in the carry trade, along with the Yen; because it is such a low interest currency (at least it has been over the past few years).  As the carry trade was "taken off" and Yen and US Dollars got "paid back" guess what happened?  The US Dollar rallied.

Why?

Borrowing money is the equivalent of selling it, paying it back is the equivalent of buying it.  That is, paying back US Dollars applies upward pressure to the US Dollar chart.  This is why the US Dollar did not collapse as many pundits predicted.  It may collapse someday, but not while it is a low interest currency and hedge funds are taking risk off.

Where does the left over cash go once all the assets are sold?

Into US Treasury Bonds, which is why the 10-year note futures and other bond futures rocket higher during these times.

Carry trade is on?  Great, buy everything.

Carry trade is off?  Get out of the way.

Successful trading,

John Frederick Carter

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