The AUDUSD carry trade – where you sell US dollars and buy Australian dollars to profit on the interest rate spread and any gains in the AUDUSD – has been been on a tear since June of last year.
But this brittle carry trade cannot handle prices below .9800 for long – and if the trade shatters, the blowout could be huge.
The AUDUSD carry trade broke down during the May “Flash Crash” last year, causing the AUDUSD to shed nearly 14% per cent in one month.
Once it became clear the world wasn’t going to end, and that the eurozone wasn’t going to default en masse, the carry trade resumed.
We are near the point where the AUDUSD Carry trade could begin to liquidate again. My expectations are that any sustained trading below .9800 AUDUSD could ignite the liquidation process.
We are near that level now…
The question is, how large could the liquidation be?
In May, the liquidation shaved 14% from the AUDUSD over the course of a month. That’s a figure we can use as a first blush comparison. However, since we’ve had a gigantic rally in the months after the flash crash, I ask: Is the real target in an AUDUSD carry trade blowout the .8050 level?
The AUDUSD is up over 25% off the May 2010 lows. After the flash crash in May, the AUDUSD resumed its upward march, putting in a top above parity (1.0000) at 1.0256 on December 31, 2010!
That’s right, the recent highs in the AUDUSD were made on the last trading day of 2010, just in time to calculate returns on the bonus. I call that “painting the tape” – way to go, Carry Traders!
So, while the AUDUSD blew out 14% during the May 2010 Carry trade unwind, we have to consider that there could be a larger blowout this time. Could the AUDUSD blow out to .8050 once again?
The question is open as to how much of this big rally in the AUDUSD was driven by the carry trade. If it is nearly all of it, then the .8050 level is again in play.
While most of the Australian Dollar carry trade has been funded with U.S. Dollars during this latest rally, there is still AUDJPY carry trade activity. The yen is making new highs, and the Bank of Japan seems to have given up after a very light intervention right after the earthquake. We are seeing continued weakness in the AUDJPY.
This puts additional pressure on the AUD, which for carry traders is not good news…
The AUDUSD Carry Trade Explained
The carry trade is a popular trade for institutional traders. Traders sell the low interest rate currency, and buy the high interest rate currency, and make a profit from the interest rate spread.
When you sell a currency, you are effectively borrowing the currency, so you pay interest on the money you borrow. When you buy a currency, you get to lend this currency out to someone, and you get payment from that person.
To put on a carry trade, all you need to do is buy AUDUSD – where you are buying AUD with a 4.75% overnight interest and selling USD with a 0.5% interest rate. The act of buying this currency pair puts you into the carry trade.
This trade works great if the exchange rate is stable – you can make 15% a year from just owning one currency over another – with a moderate amount of leverage. It works even better if the currency pair goes in your favour – like the AUDUSD has done for months now. With the huge rally in the AUDUSD, the returns for this trade were fantastic in the second half of 2010.
But carry trades are brittle! When they break, the entire trade tends to break down very quickly. That is what we saw during the flash crash of May 2010. The AUDUSD broke down and shed 14% in a matter of days.
We could see breakdown of the AUDUSD and AUDJPY carry trades as well in the coming weeks (or days). Once this starts, the entire blowout could last for an extended period as successive waves of traders are forced to liquidate their positions.
If this carry trade unwinds, how low will these pairs go?