Market Directions: The Unnatural Dollar and the Carry Trade

There is something slightly askew with a market that rallies the dollar on bad American economic news and sells the greenback on positive US developments. But such has often been the case since the dollar began its long climb to respectability back in July. This inverse relationship was particularly evident on Thursday and Friday with the US equities averages.

On Thursday the Dow completed a historic reversal closing up 552.59 points after being down over 300. As the Dow climbed in the last three hours of trading the dollar fell against the euro from 1.2520 to 1.2854, the turn being exactly coincident with the return of the Dow from its low. The pattern reversed on Friday as the Dow lost 400 points in the last hour of trading and the dollar gained almost 200 points as the euro fell from 1.2797 to close at 1.2603.

The mediating trade for both dollar moves was the yen crosses, the carry trade. Buying or selling the yen crosses has the opposite effect on the dollar and euro. If the euro/yen rises the dollar falls against the euro and the dollar climbs against the yen. The dollar is driven in the opposite direction of the cross move by what is called the ‘over dollar' trade, covering the long cross position by selling the dollar against the euro and buying the dollar against the yen. The mediating rational for this yen cross or carry trade is usually called risk appetite and risk aversion.

On Thursday afternoon as the Dow accelerated higher the yen crosses and their components all raced skyward. From 2:00 pm to 4:00 pm the euro/yen shot up from 120.00 to 126.05. Stop loss buying above 120.50 and 121.00 gave strong impetus to the move but all the yen crosses, stg/yen, aud/yen, nzd/yen, chf/yen and cad/yen followed the same pattern. The logic seemed to be that a stronger Dow indicated a lower economic risk profile and therefore it was safe or safer, to buy the yen crosses. This is normally described as a return of risk appetite in the carry trade. But is that an accurate description? Is the carry trade currently instigated by the perception of overall risk in the economic sphere?

Aversion to risk in the standard carry trade is logical. A carry trade is a medium to long term position that attempts to take advantage of the interest rate disparity between Japanese yen and other currencies. In its simplest form the holder of a long euro/yen or aud/yen position earns the spread differential between the interest rates of two currencies. Before the Europeans and the Japanese began reducing rates the interest carry was potentially 3.75% per annum in the euro/yen, (ECB 4.25% -BOJ 0.5%=3.75%) and higher for the Pound Sterling, Australian Dollar and New Zealand Dollar versions.

The currencies involved in this week's Dow inspired trading were the traditional yen carry trade pairs. But was this trading a variant of the standard risk averse, interest driven carry trade? Were traders motivated by the ebb and flow of market risk? And were the reversing moves in the Dow a good indicator of risk?

If we assume that the traditional medium and long term yen crosses are risk averse, that is if risk appetite is a major factor for traders in deciding whether to put on a long or short yen cross the question is twofold: does that motivation operate in the current trading environment and is a falling Dow evidence of a riskier economic environment and hence promotional for the selling of yen crosses? Is the reverse also true, if the Dow rises is the risk environment more benign so traders should logically go long the yen crosses? Considering the economic events of the past several months can we suggest that this volatility in the Dow represents two different risk environments?

The Dow rose 800 points from its low on Thursday; in the context of the past year is that an indicator of declining risk? Probably not. Yet the yen crosses rose dramatically along with the Dow.

The Dow closed dacown 400 points on Wednesday, gained 550 points on Thursday and fell more than 300 on Friday. This is extreme volatility. Such movements of the Dow can only mean that overall risk remains very high. If risk is extreme throughout then is it risk aversion and risk acceptance that is driving the yen crosses and by default the dollar? When the news is negative, a lower Dow, traders sell the yen crosses and buy the dollar. When the news is better, a higher Dow, traders buy the yen crosses and sell the dollar. But since neither a positive or negative Dow signals any change in the risk environment, it is quite unlikely that it is risk perception that is driving the yen crosses.

Nor do the currency gyrations, particularly in relation to the dollar, make macro sense. If anything a higher Dow might be sensibly be interpreted as supportive for the dollar and vice versa.

As we illustrated above a lower or higher Dow does not equal a change in the risk environment but continued extreme risk. If risk perception is not driving the yen crosses and by extension the dollar what could be the signals that are motivating traders?

To answer this question we must remember that the risk aversion associated with the carry trade applies most strongly to the interest rate version, that is to trades put on to take advantage of rate disparity. But the yen crosses that exhibited so much Dow inspired volatility this week were not interest rate carry trades.

These yen crosses were speculative trades taking advantage of the now ingrained reaction of the yen crosses to news and economic developments. It is a reaction that has been reinforced so forcefully since July. When system risk or perceived risk rises sell the yen crosses, when it falls buy the crosses. This mindset operates even when the respective positive and negative Dow moves represent the same thing: heightened risk.

The logical vulnerability of the interest rate based yen carry trade to volatility has become a standard trading paradigm for the yen crosses even though the original rational of the interest carry is no longer operational. To put it another way traders who went long the yen crosses as the Dow rose did not expect to hold those positions long enough to profit from the positive rate carry. But they did expect the currency markets, meaning other traders, to react as they did and buy the yen crosses. Buying the yen crosses when the Dow is strong and selling them when it is weak, is now a standard a trading play.

Markets can develop standard trading responses that, while they may be dubious in any economic cause and effect relationship, are tried and true ways of making trading profits. The supposed risk aversion and risk acceptance in the yen crosses is now such a standardized reaction. It does not represent any economic reality. But as a well understood signal for trading, it makes eminent sense for the simple reason that it works and until it changes it will continue to operate. That is why the dollar sank as the Dow rose and gained as the Dow fell. The dollar moves had nothing to do with economic perceptions of the United States economy. The dollar was a simple afterthought to the trading in the yen crosses.

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

FX Solutions

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(Chart courtesy of FX Solutions' FX AccuCharts. Price on 1st pane, Slow Stochastics on 2nd pane; uptrend lines in green; downtrend lines in red; horizontal support/resistance lines in yellow; 200-period simple moving average in light blue.)