Thursday 28th February, 2008

 

Carry-trade crystal ball?

 
 
 
 
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By Sascha Syne

senior trader, Trading Department

The past quarter has been a very interesting one, where the markets have done a full circle. Just about every asset has experienced higher volatility and the general feeling of uncertainty has most definitely grown as we try to figure out what is going to play out since this subprime debacle began.

This period is described as one where investors have low confidence in the markets. With the bombardment of articles and news broadcasts about that word we have all become too familiar with, it seems that we will remain dangling for some time until it is confirmed that the US is, in fact, in a recession or whether it will dodge the bullet.

It does not seem to matter what we trade—bonds, equities, currencies, commodities—all have experienced record level highs and / or lows, followed by reversals that might seem to indicate that the uncertainty is fading and stability is approaching. Then, all of a sudden, more volatility rears its ugly head again.

Last week we looked to the release of the Fed minutes to help provide some sort of plan or at least a direction that we may have interpreted and used to our benefit, hopefully. Well, that door was shut as it seems that the Fed did a better job of adding more confusion to the pot.

We have all tried to sort through the mess of information to figure out what to do. The only problem is that for every piece of research or news flash that suggests a particular direction, another comes out suggesting the opposite. It may be time to realise the painful truth: nobody knows what is going on and it may be prudent to just stay clear of the risk and settle into something safe like US treasuries until the bloodbath is over.

Now all we have to do is wait for a signal that confidence and market stability have returned.

The discovery of an all-telling crystal ball has not yet been made so, in the meanwhile, there may be another litmus test to help us identify when investor confidence and stability rears its pretty head.

The past couple of years have recorded strength in the equity markets as well as the heavily invested carry-trade. The focus is on these two particular asset classes and whether there is any relationship between the two.

The term carry-trade has been thrown around a lot. This is a very simple transaction where investors borrow in a currency where the interest rate is very low, Japanese yen (JPY) for example, sell that currency (which puts pressure on it to depreciate) and then buy an asset that has a much higher yield which is usually in a different currency, Australian dollar (AUD) for example, which is then subject to pressure to appreciate. The difference between the borrowing interest rate and the investing interest rate is what is called the carry. The risk in this type of trade is that the currencies can move against you; where the investing currency, AUD, depreciates and the borrowing currency, JPY, appreciates making the trade lose value.

Naturally, it should only make sense to enter this type of trade when investors believe that stability is increased.

In today’s markets, thanks to globalisation, all markets around the world are connected. When money flows from one country to another, from one currency to another to buy and sell different assets or repay different financing liabilities, the one certainty is that the currency markets will be affected by this flow of funds.

One may assume that traders are rational and that carry-trades are executed when there is confidence or a perception of stability in the markets. The trend in the equity markets is usually a good indicator of the economy’s direction, which in turn reflects the level of stability.

It only makes sense to test the relationship, if any, between the performance of the equity markets and the carry-trades. This was performed by testing for correlation and a multiple-factor regression analysis was also done to produce results that would give an idea of the overall significance.

The daily closing values of the Dow Jones Industrial Average index (INDU) and the S&P futures index (SPX) were used separately against the spread between the funding currency, JPY, and each of the investing currencies, AUD, Turkish Lira (TRY), Brazilian Real (BRL) and the New Zealand dollar (NZD). The data sets were over two and three year periods respectively.

Theoretically, the spreads should increase as the carry-trade is executed, as one currency will depreciate and the other will appreciate. As the spread increases, the equity market should perform. These tests were performed at a 95 per cent confidence level.

The results were surprising. The correlation between the performance of the equity market and the increase of currency spreads in all tests ranged from 92 per cent to 94 per cent. The regression analysis revealed R square values ranging from 86 per cent to 89 per cent. This represents a very strong relationship and proves to be very significant. There was some weakness to one of the tests, the results of the P-values which are also tests of significance for two of the currencies, TRY and BRL, were weak under the two-year test only despite the very significant R square value.

The three year test was very robust for all the currencies. Therefore, the test revealed that US equity markets perform better as carry trades are entered into and vice versa. This may indicate that investors believe there is stability in the market and are confident about the trade. However, it would be a mistake to believe that equity markets perform better as a result of carry-trades.

This may provide us with another indicator that can help us to gauge the direction of the markets. In no way should this test be used as the statistical version of a crystal ball. Many more factors come into play and all should be considered when trying to choose a particular trading strategy. Patience, knowledge, experience and a limited ego will always lead to better trading than any one tool or indicator.

 

 

 

 

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