Carry Trade Range May Not Last Through Fed's Rate Decision Tuesday

The drop in the DailyFX Carry Trade Index found a temporary floor this week, leaving the popular strategy wanting for direction through yet another month. With the basket closing out July just above a significant trendline at 28,751, the outlook for risk is once again perched on a precarious ledge. Fundamentally, there seems to be no lack of scheduled or unscheduled event risk threatening to unbalance the demand for yield and fear of capital losses.

• Carry Trade Range May Not Last Through Fed’s Rate Decision Tuesday

• Despite Heavy Event Risk Volatility And Risk Reversals Continue To Improve

• Resistance To A True Carry Rebound Read In Many Of The Individual Pairs

The drop in the DailyFX Carry Trade Index found a temporary floor this week, leaving the popular strategy wanting for direction through yet another month. With the basket closing out July just above a significant trendline at 28,751, the outlook for risk is once again perched on a precarious ledge. Fundamentally, there seems to be no lack of scheduled or unscheduled event risk threatening to unbalance the demand for yield and fear of capital losses. However, most market condition indicators suggest just the opposite – that the carry trade will settle into an extended period of congestion. The DailyFX Volatility Index fell another 0.27 percentage points to 9.46 percent – the lowest level for expected price action since late February. What’s more, the recent plunge in risk reversals has marked a sharp turn around and the spread between interest rate expectations is once again widening.

It is clear in both the index and individual carry trade pairs that caution over the future of credit conditions and interest rates is at an impasse with the desire for outsized returns. In fact, the three-month period of congestion for the income strategy is the longest the market has experienced in over two years. In a market where fear and greed are primary drivers, such an equilibrium cannot hold out for long. Considering the glut of event risk in the week ahead, the deciding break may come sooner rather than later. While the US dollar’s benchmark yield makes it a relatively ineffective carry or funding currency (as it is significantly higher than the yen’s low rate and well off the euro, pound or Aussie rates), the currency is still a barometer for the carry trade. The greenback is the most liquid currency in the world and backs an estimated 80 percent of all currency transactions – making it uniquely sensitive to the ebb and flow in this passive currency strategy. With the dollar’s importance in mind, the upcoming non-farm payrolls release and FOMC rate decision could not only define the interest rate outlook in the US, but it could also provide the catalyst for a broader carry breakout.

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What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.