What’s the Worst that Could Happen?
While global Central Banks are not cutting rates yet, their synchronized rate-hike-hiatus has made it a very real possibility heading into 2020. If that happens, the beloved carry trade will fade off into the sunset as the market punishes traders that didn’t protect their downside. Some would argue that there is still room to run in this cycle (and they may be right), but the increasing risks of implosion certainly warrant a more prudent approach to the carry trade.
Long USD/JPY and Long USD/CHF have been the most popular carry trades during the most recent tightening cycle and should remain that way if US Dollar strength and low FX volatility persists. But what happens if that changes?
If we do see the end of the tightening cycle, you will likely see liquidation begin in these positions. As most of the early exiting will come from hedge funds and other large traders, the crash could be fast and furious. The implosion is further exacerbated by the high degree of leverage in FX markets, and those who are late to the party will be in a world of pain. Once the loss on the position exceeds the average annual yield from the carry, the trade is toast.
Figure 1 - USD/JPY Weekly Chart (NetDania)
Figure 2 - USD/CHF Weekly Chart (NetDania)
Protecting the DownsideThose who are not ready to take money off the table should at least be looking to protect it. Novice traders often find themselves in a single carry trade without being hedged, which is how trouble starts. Experienced traders instead own a portfolio of carry trade positions that lowers risk through diversification. This is great if you see a drop in just a single pair, but the others move in your favour. But this alone won’t insulate you from downside risks of a broad USD selloff. This is where options come in.
calls are worth a look. The trick is finding an OTM option with a low enough premium that it doesn’t eat up your carry profits, but not to far OTM that the protection is insufficient against devastating spikes in JPY or CHF.
Another strategy that has gained traction is selling puts rather than buying calls. When Put sales are combined with a carry trade, you get additional yield from the premium. This is great in low volatility environments, but if central banks stop tightening there will be downside risks. It is more prudent to hedge these with a collar strategy to reduce costs of hedging, but you will be forgoing some upside.
Figure 3 - USD/JPY Forecast Poll (FXStreet)
Figure 4 - USD/CHF Forecast Poll (FXStreet)
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Editors’ Picks
EUR/USD holds gains above 1.0700 amid weaker US Dollar, EU data eyed

EUR/USD is posting small gains above 1.0700, finding support from a broad US Dollar weakness and hawkish ECB expectations ahead of the mid-tier EU data this Tuesday. Cautious market mood and disappointing German Factory Orders limit the upside in the major.
GBP/USD defends bids near 1.2450 amid cautious markets

GBP/USD is trading close to 1.2450, defending minor bids in early Europe. Amidst poor US economic data and increased Fed pause bets, the US Dollar takes the back seat, despite a cautious risk tone so far this Tuesday.
Gold gyrates within $1,955-73 trading zone

Gold price aptly portrays the sluggish markets heading into Tuesday’s European session, after an indecisive week. The XAU/USD highlights a lack of major data/events on the economic calendar, as well as mixed concerns about the Federal Reserve’s (Fed) moves and the diplomatic ties between the US and China.
Is the metaverse hype back in action?

Although there are no major macroeconomic events this week, investors can expect massive volatility on a daily basis. The reasoning behind this outlook is that Apple will be conducting the 2023 Apple Worldwide Developers Conference (WWDC) on June 5.
Plotting the slope for the Fed's final glide path

Given that investors have very strong recession priors and it's well understood the services sectors are driving the bulk of the post-Covid cross-asset recovery, the negative services print was viewed a tad pessimistic on a multi-cross-asset level as the summer lull beckons.
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