Tuesday, August 28, 2007

Trading Forex - What's Next for the Yen?

For the last couple of years or so, the buzz word in Forex circles has been the carry trade. In fact, it has become popular enough, that even CNBC gave it a mention on number of occasions.

What is a carry trade? In a nutshell, its a trade involving two currencies with a large interest rates differential. The premise is, that a trader sells short, or borrows, currency with a low interest rates and buys, or goes long, a currency with higher interest rates. In the process, trader pockets the difference, which, in most cases, is paid daily.

For example, having a position in USD-JPY would earn a difference between USD rates, 5.25%, and JPY rates ,0.5%, for a profit of 4.75%. In reality it would be a little less ,since brokers charge small part of this gain for their services.

While all this doesnt sound very impressive, dont forget the power of leverage, commonly employed in Forex trading. This very same trade at 2:1 leverage would earn 9.5%, at 5:1 leverage, about 24%. Of course, the leverage could be much higher. Now we can see why the carry trade has been so popular, and very profitable, over last couple of years.

JPY, especially, has become a target for the carry trade. Combined with Bank of Japan (BOJ) official policy of weak Yen, it has been increasingly sold against just about every currency of any importance. High interest bearing currencies, like NZD, AUD and GBP have reached levels not seen in decades. EUR-JPY is at an all time high. Even USD, in a massive slump of its own, has experienced sizable appreciation against JPY over last 2 years. It has become one of the easiest ways to make good money trading. Simply go short JPY, collect healthy interest rate and, on top of that, pocket very good asset appreciation. What could be simpler?

Unfortunately, everything thats too good to be true must come to an end. What could be described as a first crack in the carry trade, came in February. BOJ officials expressed concern with Yen being used to fund speculative interests. Just about that time JPY experienced a serious run up putting a lot of speculators out of action. It didnt last very long but was a poignant example of how fast and to what extent things can swing while trading currencies.

Recently, BOJ once again issued a statement, this time being concerned with a continued capital outflow, meaning Yen being converted to other currencies in search of better returns. What can be even more worrisome, is an article in a conservative and respected Japanese newspaper, Nihon Keizai Shimbun, which states weak Yen policy is no longer desirable. If true, that would signal a major shift in Japanese Monetary Authority priorities. Increasingly we can see dark cloud over carry trade involving JPY.

What does all that mean? BOJ is well known for its statements, which are guarded innuendos and vague threats of intervention. They hope markets will respond to those comments without an actual need to step in. As long as they keep talking about it, the chances of an intervention are not that high. However, if the markets continue to defy their wishes and all of a sudden there is no more comments - watch out. What most people dont realize, BOJ can ask other central banks to step in on their behalf. We know for a fact US Treasury did it at least twice about 3 years ago. With Yen being as low as it is, most central banks would likely be accommodating, should, in fact, BOJ request assistance. Such action would make respective countrys products more competitive, correcting trade balance with Japan.

Im first to admit that the above scenario is highly speculative and unlikely to play itself out as scripted. Im not a prophet of doom and gloom. Its not in anybodys interest to see the kind moves in JPY that happened in 1998. The chances of Yen appreciation are, however, increasingly more real. Speculators, especially small traders, should take a closer look at the JPY carry trade, if it is in their portfolio. One can put firm stops on existing positions. Lowering leverage is also an alternative. There is another sensible option. Simply take money of the table and be happy the party lasted as long as it did.

Mike P. Kulej is a Chief Forex Strategist for Spectrum Forex LLC. He specializes in mechanical trading systems as explained on http://www.spectrumforex.com Spectrum Forex LLC offers numerous services to individual traders. With questions and comments e-mail him at kulej@spectrumforex.com