Posted in Uncategorized, Forex | April 1st, 2008 | by Jordan
Last year brought much news about the USDJPY carry trade, or holding a trade merely to gain interest. At the time, the Japanese lending interest was far below the borrowing interest paid by US banks, investors could simply borrow in Japanese yen to deposit into US accounts and make money on the interest.
Carry trades are usually highly leveraged, forex accounts allow up to 400:1 leverage at some brokers. This kind of leverage allows an individual to control $1,000,000 in currency with just $250 down. This kind of investing is very dangerous and also compounds the effect when the markets turnover, or the trade becomes unprofitable for carry trade investors.
The dollar faces a critical problem, at this point the Federal Reserve Board is pushing rates so low that it may soon be privy to being the new carry trade currency. This has already happened with the Eurozone and the pound as the dollar is now pushing low interest rates that are a few points lower than the central bank rates in other countries. This creates unnecessary selling pressure when investors go to sell dollars and buy other currencies to profit from the interest rate difference.
When the USDJPY carry trade broke down, investors quickly bought back Japanese Yen to cover positions. This caused the yen to advance by 20% in 2007. As rates were lowered and investors lost confidence, the dollar was sold to buy yen which moved the exchange rate from 120 yen to the dollar to less than 100.
This puts a daunting strain on an already hurting US Dollar. If the same carry trade that perpetuated with the yen persists in the opposite direction with the Euro and GBP, the value of the dollar will continue to slide. In this kind of position, investors borrow dollars to deposit in Euro banks. This puts artificial selling pressure on the value of the US Dollar, causing it to correct.
Further action by the Federal Reserve to cut interest rates will only hurt the dollars value, pump up the price of commodities and cause a dollar sell off in favor of other currencies. The difference between interest rates is still tight, but a further move of 50 or 75 basis points will be the beginning of a large, multi-year carry trade. We’ll have to see how the Fed responds, surely they know that further action will create a large difference in interest rates and more selling pressure.
