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Buy the U.S. Dollar

Currencies / US Dollar Sep 17, 2009 - 07:25 AM GMT

By: Anthony_Cherniawski


Best Financial Markets Analysis ArticleWhatever happened to the Yen carry trade? 

Japanese overnight interest rates are still lower that the U.S. (10 basis points versus 25 basis points).  However, the three month Libor rates show that it has been cheaper to borrow dollars rather than yen.  In addition, the yen has been appreciating against the dollar since 2002.  So those having to buy back yen (to unwind a carry trade) have had the extra burden of currency appreciation working against them.   

Thus, the yen continues to appreciate against the dollar.  However, this relationship is also approaching a critical resistance between 1.45 and 1.50.  Can it power up over resistance?  The bearish wedge formation suggests that it is not likely. 
What has happened in the past six months has been that the yen and other high-beta currencies such as the euro, the pound and the

Australian dollar have all rallied with the equity indexes worldwide. 

This is a departure from the pre-2002 relationship, where the yen was sold (short) whenever risk appetite increased.  The traders back then took the proceeds and bought higher yielding currencies, such as the dollar. 

Now the dollar is being sold in the new carry trade and the proceeds are being applied to the equity markets.  Is this practice becoming long in the tooth?    Let’s look at another relationship.

The Euro has also been appreciating against the dollar from the same low in 2002.  What is different is that the bearish wedge has broken down in the euro-dollar ratio.  The rally since March has been counter-trend.   It has just exceeded the 61.8% Fibonacci retracement level, so the relationship may be ripe for a reversal. 

The US dollar, on the other hand, is in the final stages of a descending (bullish) wedge.  It, too, has completed its retracement of a wave 1 or A, and seems to be winding up for the pitch in wave 3 or C.  If this analysis is correct, the carry trade that is now funded with borrowed dollars will have to be unwound, or the market will do it in the form of a margin call. 

Bearish sentiment against the dollar is at an all-time high.   Those with a strong set of beliefs against the dollar will find it very hard to part (even temporarily) from them.   Strong rallies are made on the backs of panicked short sellers, as those caught short in equities in March will attest.  An open mind and stop loss may be a good idea, if short the dollar.

In summary, those planning on a weak dollar funding a carry trade for the foreseeable future may be taking on a double risk; the first may be having the funding mechanism (dollar) become too expensive and the second may be the assets held may have more risk than what was bargained for.   The yen carry trade may come back after all.

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As a State Registered Investment Advisor, The Practical Investor (TPI) manages private client investment portfolios using a proprietary investment strategy created by Chief Investment Officer Tony Cherniawski. Throughout 2000-01, when many investors felt the pain of double digit market losses, TPI successfully navigated the choppy investment waters, creating a profit for our private investment clients. With a focus on preserving assets and capitalizing on opportunities, TPI clients benefited greatly from the TPI strategies, allowing them to stay on track with their life goals

Disclaimer: The content in this article is written for educational and informational purposes only.  There is no offer or recommendation to buy or sell any security and no information contained here should be interpreted or construed as investment advice. Do you own due diligence as the information in this article is the opinion of Anthony M. Cherniawski and subject to change without notice.

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