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
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 tradebonds, equities,
currencies, commoditiesall 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 todays 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 economys 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
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
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.