Gianluca Privitera, CIM
Independent Analyst
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 climbs to daily highs near 1.1820
EUR/USD now picks up pace and advances to the area of daily peaks north of the 1.1800 barrier at the end of the week. The pair’s decent move higher comes against the backdrop of a generalised lack of direction in the FX galaxy and the mild offered stance in the US Dollar.
GBP/USD trims losses, retests 1.3460
After briefly challenging its key 200-day SMA near 1.3440, GBP/USD now manages to regain some balance and revisit the 1.3460 zone on Friday. Cable’s pullback comes as the selling pressure on the Greenback gathers traction, reigniting some recovery in the risk-linked space.
Japanese Yen gives back half of early gains against USD ahead of US PPI data
The Japanese Yen (JPY) surrenders half of its early gains against the US Dollar (USD) during the European trading session on Friday. The USD/JPY pair rebounds to near 155.90 as the JPY falls back, but is still 0.15% down.
Editors’ Picks
EUR/USD: Fed calm, ECB steady, but the Dollar still leads Premium
EUR/USD is still struggling to find real traction. The pair has tried to stabilise, but momentum keeps fading, leaving the door open to further weakness.
Gold: Falling US yields, geopolitics help XAU/USD hold ground Premium
Gold (XAU/USD) gained traction and climbed above $5,200, ending the fourth consecutive week in positive territory. The next round of US-Iran talks and crucial macroeconomic data releases from the US will be watched closely by market participants in the short term.
GBP/USD: Will Pound Sterling defend key 1.3450 support ahead of US jobs data? Premium
The Pound Sterling (GBP) entered a bearish consolidation phase against the US Dollar (USD), after having tested critical support near the 1.3450 level on several occasions.
Bitcoin: Another month of losses, and it’s been five
Bitcoin (BTC) price is stabilizing around $68,000 at the time of writing on Friday, but the Crypto King is poised to close February on a fragile footing, marking its fifth consecutive month of losses since October and a rare start to the year with back-to-back monthly corrections.
US Dollar: At a crossroads; Fed steady, tariffs in flux Premium
The US Dollar’s (USD) upward momentum from the previous week seems to have encountered a tough nut to crack in the 98.00 region, as measured by the US Dollar Index (DXY).
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