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Thunder From Down Under

Thu, Mar 29 2007, 09:06 GMT
by Online Trading Academy Team

Online Trading Academy

By Ed Ponsi

The Australian Dollar smashed through resistance to reach a new 10-year high against the U.S. Dollar last week (see figure 1). The Aussie was also dominant against the Euro, the British Pound, and the Canadian Dollar, among others.

Figure 1: Weekly chart shows the Australian Dollar breaking through resistance vs. the U.S. Dollar. Source: Saxo Bank

Why are we hearing a deafening roar of thunder from Down Under? Strong economic growth has traders believing that the Reserve Bank of Australia (RBA) will raise interest rates from the current 6.25% to 6.50% at their next meeting on April 4. Recent comments from Australian Finance Minister Nick Minchin, who stated that the country's growth would exceed previous government estimates, only serve to reinforce this notion.

This brings up an important point - traders don't wait for the actual rate increase to step into the market and buy the Aussie. Similar to the way that stock traders "buy on the rumor, sell on the fact", currency traders are operating under the assumption that an Australian rate hike will occur in the near future, and they are buying now in anticipation of this event. Because of this, the rate hike is being "priced in" to the market before it actually occurs.

Quick Fact

In 2006, housing prices in Japan rose for the first time in 16 years.

The huge gains in housing values over the past several years in the U.S., U.K., and many other countries make this fact a real head-turner. Imagine if the value of your home had been flat or falling while housing values skyrocketed nearly everywhere else. This illustrates what life is like in a deflationary environment, and why Japan, with inflation currently hovering near 0%, is going to have a tough time raising interest rates beyond the current 0.5% in the near future. Higher rates could drive inflation back below 0%, possibly triggering a deflationary spiral in the process.

Question of the Week

Q) I'm not really clear on how much interest I'll receive if I short a low-yielding currency (such as the Japanese Yen) against a higher yielding currency (for example, the New Zealand Dollar). My broker is giving vague answers. What should I do?

Ed Ponsi) Thank you for your email. First, let's get everyone caught up on the concept at hand. Every currency pair contains two currencies, and each currency has a corresponding interest rate, set by that country's central bank. Here are some of the current rates:

New Zealand Dollar 7.50% (NZD), Australian Dollar 6.25% (AUD), Great Britain Pound 5.25% (GBP), U.S. Dollar 5.25% (USD), Canadian Dollar 4.25% (CAD), Euro 3.75% (EUR), Swiss Franc 2.25% (CHF), Japanese Yen 0.5% (JPY).

Here's how it works: the rate in the U.S. and in Great Britain is currently 5.25%. Since there is no interest rate differential, (5.25% - 5.25% = 0) traders should not be charged or credited with interest when trading the Great Britain Pound vs. the U.S. Dollar (GBP/USD).

Let's assume that the U.S. Federal Reserve cuts rates by a quarter point to 5.00%, and the Bank of England raises rates by the same amount, to 5.50% - which is not a farfetched scenario by any means. This would change the differential to 0.5% (5.50% - 5.00% = 0.5%). Traders who are long the higher-yielding currency (GBP in this case) will receive interest, and traders who are long the lower-yielding currency (USD) will pay interest. Because the differential is small (0.5%), the interest credited (for those who are long GBP) will be small, and the interest payments (for those who are long USD) will also be small.

How much interest you'll receive is a function of the interest rate differential. Over the past year, many traders have used the strategy of going long a high-yielding currency (New Zealand Dollar, Australian Dollar) vs. the low-yielding Japanese Yen. This is the so-called Forex Carry Trade, which hedge funds have been using for years (and which CNBC finally discovered last month). The interest rate differentials on these trades are very high, so the amount of interest one can collect is also high (see figure 2):

New Zealand Dollar/ Japanese Yen (NZD/JPY) differential = 7.0%

Australian Dollar/ Japanese Yen (AUD/JPY) differential = 5.75%

Great Britain Pound/ Japanese Yen (GBP/JPY) differential = 4.75%

Figure 2: Traders who have been long the Australian Dollar vs. the Japanese Yen (AUD/JPY) have reaped huge gains in addition to collecting substantial interest payments. Source: Saxo Bank.

You might recall that just four weeks ago, a variety of Chicken Little analysts were all over your television, proclaiming the death of the Carry Trade. Two weeks ago, I wrote an article called "Demise of the Carry Trade?" which explained in depth why strength in the Yen would be difficult to sustain, and pointed out that currencies such as New Zealand Dollar and Euro were still trending higher vs. the Yen.

Well, in the two weeks since then, NZD has gained 300 pips vs. the Yen, and is nearly at levels prior to the so-called meltdown (see figure 3). Euro has also made a healthy gain of over 200 pips vs. the Yen during that time. In the meantime, we have heard nary a peep from the Chicken Little analysts. I guess the sky isn't falling after all!

Figure 3: New Zealand Dollar has regained nearly all of its prior losses vs. the Japanese Yen. Source: Saxo Bank.

Consider this - if support or resistance exits on the daily chart, it exists on intra-day charts. Why? Because the intra-day chart is just a microcosm, a small slice of the daily chart. You could say that a 15-minute chart contains the same information as the daily chart, except that the information is broken down into smaller pieces - for example, a daily candle is equal to ninety-six 15-minute candles. If major support exists on the daily candle, it also exists within all ninety-six of those 15-minute candles, regardless of whether or not it is visible in short time frames. Because of this, short-term Forex traders look to the longer-term charts as both a directional guideline (is the currency pair in a trend, or is it rangebound?) and as a filter (is the price nearing major support or resistance?).

Issues With the Broker/Market Maker

Getting back to our earlier question, there is something wrong if your broker can't simply tell you how much interest you should receive - and under what conditions you should receive it - on any given currency pair. Try asking these questions:

1. Under what circumstances can I collect interest? For example, do I have to reduce my leverage in order to receive payments? The reason why we need to ask this is because some market makers require that you reduce your maximum leverage (to 50-to-1 for example) in order for you to collect interest. That same broker may not be willing to pay interest if you are using leverage of 200-to-1. These rules vary from broker to broker, but each individual broker is certainly aware of their own rules.
2. What method is used to determine the amount of interest? For example, does the market maker pay interest on a daily basis? Some currency traders receive a small 'dividend' every day just for being in the trade. The daily calculation is the most commonly used method, but some credit or charge interest in shorter increments.
3. Is there a spreadsheet or similar tool on the trading platform that allows traders to see the exact amount of interest that they will be credited (or charged) for a given currency pair? If not, how is this figure calculated? Many brokers have the information right on the trading platform, and you might be able to view the info simply by opening a demo account or by visiting the market maker's website.

Published on  Thu, Mar 29 2007, 10:24 GMT