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Volatility and the Carry TradeMarket Directions November 02, 2008
The demise of the carry trade and its associated components is without parallel in the history of modern currency trading. But the extraordinary rise and fall of the carry did not take place in the isolation of the currency markets. It was part of the worldwide search for trading profits fueled by cheap credit, leverage and the ability to flash money around the world in an electronic instant. The same factors that propelled the carry higher and then wrote its collapse drove the commodity markets, the mortgage industry and equities to success and distraction.
Instead of looking at the carry trade in light of traditional parameters for the currency markets--interest rate differentials and the competitive economic conditions of the currency countries--let us consider it from a credit and leverage point of view. What effect did the tremendous increase in available credit for currency market participants have on trading in the yen crosses? What will be the effect of its sudden and probably permanent withdrawal?
Credit availability in the cross currency market had a two-fold impact. First, it encouraged participation in the currency markets for traders and non-bank organizations. The seemingly permanent rise in the yen crosses was at least partially fueled by players seeking the sure return of the carry trade. Not only was there positive carry or interest earned on the trade but buying the crosses drove the cross rates and the value of the positions ever higher. It was a double benefit: interest rate carry and position appreciation.
Whether participation in the carry trade stemmed from the need to exchange funds borrowed at very low rates in Japan for use elsewhere or for differential interest return and speculative profit, the effect on the cross rates was the same; they were pushed relentlessly higher. The Euro, the Pound Sterling, Australian Dollar and New Zealand Dollar were all propelled to historic highs against the US Dollar at least partially as a side effect of the carry trade and what is called ‘over dollar’ covering of cross positions.
For example, when traders want to take a long euro/yen position they can directly buy the cross in the currency market, or they can buy the euro against the US dollar and sell the yen against the US dollar and combine the position into a long euro/yen position. The reason for this slightly more complex transaction is price, sometimes you can obtain a better rate ‘over dollar’ that you can in the cross itself. This procedure works with all the yen crosses.
The second effect was, and pardon the use, derivative. The availability of credit encouraged increased participation in the carry trade, and this heightened participation served to decrease volatility which in turn increased the predictability of profits. It may seem counterintuitive that the more interest there is in a specific market the lower the volatility. But the effect is a function of the available liquidity.
In general, the more liquidity there is in a market the more stable the pricing. Liquidity means that at most price levels traders will want to do deals. It takes a liquid market longer to traverse a price range and a shorter amount of time to dissipate news. Smaller currencies, smaller in terms of trade volume, are inherently more volatile. As the market moves in response to news or deal flow they have fewer deals to absorb the selling or buying. A much smaller amount of volume can move the market. Other factors being equal volatility rises as liquidity falls.
Volatility is, of course, not only a fact of low market liquidity. External events are of equal or greater importance. As we have seen so dramatically over the past eight weeks, fear can propel markets far beyond what would have once been considered rational prices levels.
One of the ways external factors influence price movement is that they can limit liquidity. Players may choose to curtail their risk by not participating in trading. This is certainly one of the factors that have given all markets such a violent aspect in the past two months. Many potential new buyers have stayed on the sidelines.
And that leads us back to the yen crosses. The daily ranges of the crosses over the past two months are much greater that the average of the previous five years. It is not only risk aversion that has slammed into long yen cross positions causing so much liquidation. The cessation of credit has contracted participation in the market. As credit lines have been withdrawn from market players and yen loans liquidated the participation rate and the trading volume in the crosses has dropped. The sellers have been under compulsion, the buyers are voluntary and absent.
The credit crash has affected participation rates in all markets. Many speculative players who depended on credit and leverage to fuel their trading have withdrawn. They will not return anytime soon. In the currency markets this permanent drop in liquidity may keep price movement volatile long after calm has returned to other markets. It has substantially diminished liquidity in the yen crosses which were, for so long, the speculative favorites of currency traders.
FX Solutions, LLC
Chief Market Analyst
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