The Carry Trade That’s Set To Unravel

Lior Alkalay - INO.com Contributor - Forex


Carry trade... if that’s the first time you’ve come across that term you should know that "carry trade" is one of the oldest tricks in the books when it comes to foreign exchange trading. It is based on a very basic gap, specifically, the interest rate gap. The way investors use it to create alpha is by borrowing one currency with a lower interest rate and buying with the borrowed cash a currency with a higher one. The investor's gain is created then by the gap between what the borrower pays on the low yielding currency and what he earns on the high yielding currency. Of course, if the currency you buy appreciates in the process that would be even better.

Investors have been making good (i.e. profitable) use of this technique for years using various currencies. For instance, back in the 1990s and 2000s, investors would borrow the Japanese Yen, then buy the U.S. Dollar or Euro. Or as in the 2009-2010 period, they’d borrow the U.S. Dollar and buy the Euro (of course, back then rates were much higher). Usually, this would create inflows for the higher yielding currencies and as such lead to the currency’s appreciation. But what happens when this rate gap is threatened? As Euro bulls discovered just recently, it can create a meltdown of the trade rather quickly and the trend can reverse course just as fast. So, why am I telling you this? Why the sudden dive into the mechanics of the carry trade? Because just as you are reading those very words, a big carry trade is set to unravel and as it does, the trend it created is set up to reverse as well.

The Aussie Kiwi Carry Trade

One of most prominent carry trades of the past two years has revolved around the currencies of two neighboring countries, Australia and New Zealand. Ever since China’s economy began slowing and the commodity space began its bearish cycle, the Australian economy has likewise been slowing and, of course, as a result interest rates were cut to prevent the Aussie economy from further deterioration. However, while Australia suffered a slowdown, New Zealand, its smaller neighbor, has been faring well and growing above trend, thanks in large part to a prosperous dairy industry. Naturally, this created an interest rate deferential which is illustrated below and, as you might have guessed, a big carry trade that led the AUD/NZD to an utter collapse of 20.9% until it reached a multi-year low of 1.049. Yet, now as the pair is trading close to its record low, there are tentative signs emerging which suggest a turnaround could be in the making. This could lead the trend to reverse and allow investors to potentially bank on a big rebound of the AUD/NZD. Image courtesy of TradingEconomics.com.

New Zealand Interest Rate - Dec 2014

The Trend Unravels

So, why is the trend on the verge of unraveling? In one word: inflation. If Australia had lower interest rates along with a rate of inflation lower than New Zealand’s own, the trend would have no reason to reverse. Australian interest rates would remain low (or else be at risk of dropping lower), while New Zealand would have rising inflationary pressures that would justify higher rates. But that is not the case at all. In fact, Australia’s annual inflation rate is more than double New Zealand’s. Aussie inflation was reported at 2.3% YoY while New Zealand’s inflation stands at a mere 1%, and that is in spite of the one-off effect of a reduction in Australia’s electricity tax that lowered inflation. In other words, while interest rates in Australia are much lower, the inflation rate is much higher, shaking the fundamentals of the trend. This means that while the Reserve Bank of Australia (RBA) has neither the space nor the rationale for easing, the Reserve Bank of New Zealand (RBNZ) has at least one reason to cut rates and none to raise them, leaving the fundamentals of the short AUD/NZD to crumble and open the space for a rebound. Image courtesy of TradingEconomics.com.

Australia Inflation CPI

Price and Projections

But now, there’s one final question, does the market show signs of a trend reversal in the AUD/NZD? The answer is yes. As seen below, each and every time the pair moved nearer to its record low of 1.049, buyers emerged. In fact, since the beginning of the year, buyers for AUD/NZD seem to reemerge, each time at a higher point, signaling a clear, albeit slow, sentiment shift. However, given that the RBNZ rate decision is set to take place next week and considering that the RBA took a decidedly neutral turn this week, the likelihood of an AUD/NZD trend reversal is on the rise, especially as the RBNZ governor continues, time and again, to point out that the Kiwi Dollar is "unjustifiably high." If that winds up being the case next week as well, that trend reversal could quickly accelerate. And as far as projections go? Looking at the chart, logically, we could be looking at a reversal toward at least 1.14 as this Aussie Kiwi carry trade unravels over the next couple of months.

AUD/NZD Monthly

Look for my post next week.

Best,

Lior Alkalay
INO.com Contributor - Forex

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

Leveraged 3X ETFs Are Much More Dangerous Than You May Think!

Matt Thalman - INO.com Contributor - ETFs


Due to market demand, over the past few years we have begun to see another increase in investors' use of leverage. Just ten years ago all the rage was using leverage to buy more home than one could really afford. Before that, it was the increased use of credit cards and way back in the late 1920's it was trading stocks on margin. The use of leverage has time and again blown up in the faces of those who use it at an abusive level.

So today I would like to point out some of the dangers of Leveraged ETFs or better known as 3X ETFs. But first, let's talk about why it's hard to see the danger in these investments. I believe the most glaring reason is because we have been told that ETFs, or any group of investments bundled together in order to provide diversity, is safer than buying individual stocks or investments. And that is completely true, but what makes the leveraged ETFs dangerous is the leverage itself.

Deterioration Risk

The first item to consider is what it costs the ETF to gain 3X leverage. That price is often referred to as deterioration risk. The deterioration of invest-able capital is due to the price the ETF must pay other financial institutions to buy and sell investment instruments in order to gain the 3X price movement of the underlying ETF asset. If the ETF is invested in the oil industry for example, the industry itself will have a limited number of financial instruments to invest in, and often times those instruments will have very little liquidity. The lack of supply and lack of demand for the investment therefore pushes the price of the investment higher for the ETF to purchase. In turn, and over time, that increased cost will deteriorate part of the capital being used to invest.

Daily Trading Only

The next issue is the use of leverage and how it makes returns very unpredictable, especially over long periods of time. Direxion Investments is one company who offers leveraged ETFs. On their website, as well as in the profile summary of each of their leveraged ETFs, you can find a warning to investors which reads:

"These leveraged ETFs seek a return that is +300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day."

Continue reading "Leveraged 3X ETFs Are Much More Dangerous Than You May Think!"

Go Nuclear

Adam Feik - INO.com Contributor - Energies


What’s working right now in the energy sector?

I’ll give you 6 ideas in this article.

I track over 100 energy investments in my MarketClub portfolio. My list includes drillers, refiners, shippers, coal, solar, MLPs, and pretty much every other corner of the sector. Today, out of 100+ candidates, only 6 are registering a green Trade Triangle signal for both the long-term and intermediate-term trend. (Green Triangles are a sign of a trend that remains intact and invest-able, although the Triangle system does not purport to capture the exact high or exact low point of any trend).

Here are the 6 diamonds in the rough:

The first two – and this deserves a groan, I admit – are "short" oil funds. I’m not telling you anything you don’t already know to say that oil prices have been plummeting since this summer. As a result, short funds are among the few energy-related investments that have performed well lately... and extremely well, at that. "Short" funds, of course, profit when a market declines, so if you want to bet that oil prices will continue to fall, DDG and DUG continue to display all green Trade Triangles. 


DDG is the ProShares Short Oil & Gas fund, which is designed to deliver one-to-one inverse performance (-1x) compared to oil prices. For a slightly higher-octane version of the same strategy, use DUG, which is the ProShares Ultra-Short Oil & Gas fund. DUG is sold as a -2x, or two-to-one inverse fund. Be advised, both DDG and DUG can be highly volatile, and much of the "easy money" has likely already been made! So keep a sharp eye on either of these investments and/or use tight stop-loss orders.

The next two "in-favor" energy investments are related to uranium. Hence, the title of this article to "go nuclear." Last week, INO.com posted a fantastic interview of Casey Research’s Marin Katusa, author of the new book, The Colder War. In the interview, Katusa touted Uranium Energy Corporation (UEC), which happens to be one of the few energy investments with green Trade Triangles right now. See the interview for some of Katusa’s interesting observations and insights about the company. Caution: Katusa advised being highly selective in the uranium category, and indeed, out of a dozen or so uranium companies on my watchlist, UEC is the only pure uranium play that’s working right now. The second uranium-related investment is not a pure play, but rather a fund that invests mostly utility companies involved in nuclear power generation. The fund is the Market Vectors Uranium + Nuclear Energy ETF (NLR). The fund’s sponsor says the fund’s objective is essentially (paraphrasing) to invest in companies whose long-term strategy is to either derive 50% of their business from uranium or to be substantially involved in nuclear power. Only 2.4% of the fund is invested in companies considered to be part of the energy sector, while over 70% of the fund operates within the utilities sector. While not a pure energy play, NLR does aim to profit from nuclear power, and right now the strategy is working (as evidenced by recent performance). Continue reading "Go Nuclear"