There are a number of necessary conditions that need to fall into place in order to promote the use of carry trades on a wide basis among leveraged investors. Credit needs to be ample enough so that borrowing is comparatively hassle free. One needs to be able to borrow in a weak currency, with a low interest rate and invest in higher yielding or better performing assets elsewhere. It helps if there is a wide disparity between the performance of the economies one is borrowing in relative to where one is investing.

Prior to the credit bust in 2008, the Yen was the primary funding currency for carry trades. Liquidity was ample, the currency was in a well defined downtrend and interest rate differentials between Japan and other countries were wide enough to justify the risk. Since the unwinding of those carry trades, the Yen has been comparatively strong, sending speculators in search of another funding currency. Two candidates presented themselves. The US Dollar and the Pound. Both have close to 0% interest rates and have made vast sums available via the discount window to the larger financial institutions. Both currencies have been in downtrends until comparatively recently, particularly against currencies where wide interest rate differentials exist such as Brazil, Indonesia or South Africa among others.

The weakening of the US Dollar and Pound against higher yielding currencies contributed to the performance of stock and bond markets particularly in destination markets for carry trades such the higher profile Asian and Latin American economies. An inverse correlation between funding currencies and destination markets was evident for a number of months but has degraded somewhat since October.

The Dollar Index continues to hold above 78 and would need to sustain a move below 76.5 to question potential for further higher to lateral ranging. The Pound Trade Weighted Index broke upwards from the two-month range earlier this month and has so far sustained the advance. The Yen Trade Weighted Index continues to rally from 120, which was a prior area of support and would need to sustain a move below that level to question potential for further higher to lateral ranging. The Euro/Yen rate is probably not as relevant to carry trades today as was the case prior to Q32008 but the Euro broke down against the Yen last week and has so far sustained the decline. The Asian Dollar Index has pulled back into the previous range and the Latin American Dollar Index appears to have completed a medium-term top and needs to rally sharply to question that view. These charts suggest that potential funding currencies are strengthening which will invariably be pressuring anyone with an implied or actual short.

While funding currencies now have successions of higher lows supporting their short-term advances, most stock markets have only recently pulled back from new recovery highs. Some such as the S&P 500 have registered failed upside breaks while others such as the Euro Stoxx 50 have pulled back more sharply and are now testing the progression of higher reaction lows. Perhaps the pattern since October will remain in place and they will unwind their short-term oversold condition and rally back to another incremental new high. However, if funding currencies continue to strengthen, putting pressure on leveraged traders in the process, this will remove an important demand demographic from the market; potentially limiting upside potential. Therefore, monitoring the extent to which funding currencies continue to advance is likely to provide valuable insight into where money flows are heading. Clear upward dynamics on stock market indices are required to indicate demand is returning to dominance.

Mean reversion, defined in terms of the 200-day moving average, has already taken place for a large number of stock market indices, but it is important to remember that support needs to be found in the region of the MA rather than the exact level for the bull market hypothesis to be sustained. I believe the experience in 2004 where major stock market indices such as the S&P500 and Euro Stoxx 50 mostly ranged with a downward bias is instructive as an example of such an event and may provide a template for the current environment.


Sugar Caught in 'Perfect Storm', May Jump on Deficit by Thomas Kutty Abraham, Ivory Coast Cocoa Crop Is Threatened by Swollen-Shoot Disease by Monica Mark and Starbucks Buying May Push Peru Coffee Sales to Record by Alex Emery all from Bloomberg may be of interest to subscribers. Here is a section from the first