When something looks too good to be true, it usually is. Today, somebody will learn an expensive lesson when it comes to the growing number of carry traders who are not paying attention to the macroeconomic signals around the world. In short, too many have become too focused on differentials and are ignoring economic fundamentals.
The retail FX traders in Japan are giving the biggest kick to the market at the moment. Over the past two or three years there has been a huge increase in margin trading by people working a nine-to-five job leveraging FX accounts.
Carry traders have done very well. Asian central banks and other Asian retail investors have bought US treasuries in large numbers and have also piled money into New Zealand and Australia.
As liquidity has increased, along with the increasing focus on automated short term trading systems, volatility has fallen. Most central banks follow a fairly consistent path in their guidance to the financial market due to the need of high credibility as well as stability. This does not open up for a lot of divergence, so the forecasts of what is going to happen to rates six months from now is closely followed by reality – there is not much deviation from expectations.
Without the high volatility of two to three years ago, people no longer worry about global imbalances, i.e. the US balance and current account. People are willing to take more risk because the chance of them losing a lot of money is small when volatility is low.
We see a lot of retail clients in Japan saying: “How hard can this be? You buy some dollars and sell some yen, make some interest.” But if it was that easy making money in any financial markets, we’d all be millionaires. Somebody has to give and we believe it is going to happen this year, triggered by an alteration in macroeconomic conditions most likely to take place in the US, Japan or New Zealand.
Macroeconomic Realignment
Saxo Bank believes that the round of interest hikes that has given rise to the gains in the carry trade is coming to an end. In the eurozone, in the UK and the US, the rate hike cycles are almost done while the Bank of Japan shows no signs of starting.
The US growth has been better than forecasted, but core price inflation still isn’t showing the growth that many analysts forecast. People are focusing on continuing high yields in the US, but, at the time of writing, we don’t believe there is confirmation enough to do that until Q2 GDP growth figures are released in the end of June. We think that it is going to be the most important number going into autumn trading. If you see core inflation again coming out low then you are going to see very many people disappointed. If that happens, you could see rates stagnate and maybe even fall, perhaps by March next year.
Japan
Many analysts and economists have talked over the past couple of years about what the Bank of Japan (BoJ) ought to do – i.e. raise rates – without actually listening to what BoJ officials have been saying. BoJ has been very clear that they would like to see a sustained rise in inflation before they can move onto a rate hike cycle. When you also consider that perhaps 30-40% of Japanese voters are long on the dollar/yen, it isn’t surprising that there have been no moves to raise rates by BoJ, no matter how much it may want to.
We haven’t seen a positive consumer price index (CPI) on a month-to-month or quarter-to-quarter basis for six months in Japan. The labour market has been tightening and as the Japanese investors become more confident, things will start moving. BoJ is ready to move quickly once these criteria are met.
New Zealand
New Zealand is a good example of a trade run by retail investors who are concentrating on yield rather than economic fundamentals. But because of the low volatility, traders are not worrying about the fact that the current account is 10% of GDP – where four years ago they would have sold off. We believe that when New Zealand falls apart – and it will – the rest of the carry trade will follow. The first time people start trading on current account data or GDP then we’ll see a reversal in carry trades. But as long as New Zealand is a carry trade environment, which means the NZ$/yen NZ$/dollar can go higher, then the carry trade will survive.
We expected the Royal Bank of New Zealand would go to 7.75%, but with 8% we believe we have seen absolutely the last hike in New Zealand. At some point in time traders are going to have to start realising that the future yield/differential potential can only be negative, because at some point Japan is going to have to get away from 50 basis points.
Based on the current situation, Saxo Bank suggests that clients buy NZ$/yen puts on a six- to 12-month basis and we are very close to seeing the levels we want to take the six-month puts. The risk-reward of staying long in carry trades is not that great any more, whereas if you buy NZ$/yen GBP/yen puts way out of the money, you can get risk-reward scenarios that are nearer one to 10, one to 20.
In Japan you are going to see the big funds betting money on carry trades being dissolved as soon as you see volatility begin to pick up. Not on a daily or weekly basis, but on a month to month basis. It is so difficult to time because if you are a fund manager and you want to be long yen and short NZ$ or AU$, then you want to be absolutely sure that volatility is up and things are about to happen, otherwise you are going to be sitting in that position losing money every single day in your carry.
If we were carry traders we’d look for another month at the most then take the profits and find something else to put our money into. Maybe European rates, possibly bonds, but we certainly would be long NZ$ or US$/yen on the shorter term.