Interest in the carry trade has faltered this past week, but it is clear from price action in the high and low yielding pairs that the market isn’t ready to give in to risk. Over the past week, both NZDUSD and AUDUSD have seen considerable pull back from the multi-decade highs. On the other hand, there has been a break in momentum at the short end of the yield curve. The Japanese yen’s steady advance has been stalled with a sizable reversal across the FX market.
What’s more outside the volatility of the spot currency market, money market rates have actually held relatively consistent across the yield curve, suggesting the market is waiting for a clear outlook on the health of the financial markets and global growth. Through the past week, exogenous news has done little to improve the general appetite for risk. Two major investment banks announced sizable write downs on debt-related losses, bond insurer FGIC saw its credit rating slashed to a level just above junk, and Fed Chairman Ben Bernanke forecasted a recession for the world’s largest economy. Besides tomorrow’s NFPs release and the G10 meeting scheduled next weekend, there are few scheduled events on the horizon that could ultimately guide risk trends. Therefore, the market will likely rely on general sentiment and surprise news to guide the carry trade.
Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum.
What Are We Currently Long?
NZD/USD
AUD/USD
GBP/USD
Additional Information
Making profitable carry trades are not as easy as they use to be. Therefore we have created a dynamic carry basket that changes when the monetary policy outlook for a central bank changes or if there is significant event risk ahead. Follow the performance of the DailyFX Dynamic Carry Trade Basket
What is Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Money shifts from around the world in seek of the highest yield and the benefit of trading currencies is that you are dealing with countries that have interest rates, which are charged or received every single day. If you are positioned on the side of positive carry, you have the right to earn that interest, which can be quite lucrative over time.
Protective Stop-Loss
Substantial gains made from interest rate differentials provide undeniable evidence that the carry trade strategy has been very successful over the past few years. Still, this strategy involves significant risks and an adequate protective stop is required. We are using a protective stop-loss equivalent to five times the average true range. Stop losses are activated when we have a weekly close below the specified stop level.
Position Sizing
Our position size varies according to each currency volatility. Generally, the more volatile the currency is, the fewer lots we trade. For example, let's assume you have $10,000 and you are trading 10K lots, you decide to limit your risk per trade to 3% or $300 and the 90 days average true range for the EURUSD is 100 pips. In this case, if you go long EUR/USD you could buy 3 lots, since ($10000 * 3%) divided by (0.0100*10K) = 3 lots. In case the final result is not an integer you should always rounded it down to limit your exposure.
