ECB provides clue to new carry trade

October 5, 2014 07:02 PM

While the strength of the U.S. dollar has been the main focus of the talking heads on TV, I would argue that the more interesting story relates to the weakness of other currencies. Take the euro, for instance. It has been weakening against the U.S. dollar since early May of this year when the European Central Bank’s (ECB) Mario Draghi said the ECB would do whatever it takes to stimulate the Eurozone economy faced with disinflation concerns. We have been getting disappointing economic data out of China since early summer, negatively affecting the economies and currencies of countries such as Australia and New Zealand, which depend on China’s strength. The Russian ruble has come under pressure also because of ongoing tensions with the Ukraine. The British Pound was shaken a bit by the Scottish vote on independence that was closely watched by market participants and political commentators. In contrast to turmoil elsewhere, the U.S. economy is arguably seeing the tepid recovery grow into a robust one with the Federal Reserve finalizing the details of an exit strategy from it extraordinary accommodation.

In the aftermath of the 1929 Great Depression, many economists – chief among them John Maynard Keynes – shifted their focus from the supply side to the demand side, encouraging governments to use both monetary and fiscal policy tools to stimulate economic growth.

In the 1990s, we saw Japan attempt to fight off a recession by devaluing the Japanese yen and lowering interest rates, hoping to spur economic growth by inflating the country into economic strength. Instead, the land of the rising sun saw a lost decade characterized by very minimal growth.

Ben Bernanke’s academic work focused on studying all aspects of the Great Depression, leading him to rely heavily on these insights in guiding the Fed through the most recent financial crisis of 2007-2009. And unlike the Bank of Japan (BOJ), the Bernanke Fed stretched the limits of monetary policy to unimaginable levels, setting a new standard in applying economic stimulus.

While many of the consequences of stimulating economic growth through currency devaluation and cuts in interest rates are known and intended, some are not. In the case of Japan’s lost decade, for example, a depressed currency and low interest rates led to carry trading. This saw institutional investors borrow yen in Japan at very low interest rates, exchange these funds into another currency and invest in markets with much higher returns. A popular destination for funds obtained in this way were emerging markets, offering investors attractive rates of return.

If we have learned anything, it is that central bank intervention tends to last many years, creating new trends along the way. For this reason, the saying “Don’t Fight the Fed!” proved to be a meaningful guide to profitable trading over the past five years. Perhaps the same will be the case with regards to ECB intervention, and the potential trading opportunities created as a result?

The futures and options on futures currency markets provide speculative investors as well as hedgers in both the retail and institutional space with plenty of opportunity to trade the ideas discussed above. From a speculative point of view, the most straightforward strategy would be to get outright long Dollar Index Futures or, conversely, short euro futures. Alternatively, market participants could look to outright buy calls in the Dollar Index or, approaching the scenario from another angle, go long puts in the euro. Outright futures or options on futures can also be used to add alpha to existing equity portfolios. Since commodities are priced in U.S. dollars, the asset class’s value should go down in reaction to a strengthening greenback. Hedge any exposure by going long Dollar Index or, alternatively, short the euros to offset any losses. Taking it to the next level, there are a number of options strategies that can be used to speculate on or hedge with more specific performance and/or risk management goals in mind.

The chart below shows the euro vs. the U.S. dollar on a monthly basis. Note, in particular, that larger technical trends tend to be in place for years, with the latest move down that began in May of this year potentially just constituting the beginning. The underlying fundamental theme here is that if the most recent Fed intervention is anything to go by, the ECB’s anticipated intervention may last years, ringing in new currency trends along the way. After all, it has been five years and the U.S. Fed is only just ending Quantitative Easing (QE).


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