The carry trade in Forex markets

The term Carry Trade indicates those operations in the forex markets that exploit the differences between interest rates by borrowing money in those markets where it costs less – and therefore the rates are lower – and employing it where higher rates allow returns conspicuous. The return of the debt resources with a lower interest rate makes it possible to make a profit on the differences between the various markets. The use of financial leverage makes it possible to multiply the returns on operations, but also increases the risks taken by traders. For this reason, in the forex markets, solid currencies are often chosen to avoid excessive volatility. To avoid the particular risks of assets that are not liquid or have a different risk profile than that of the reference country system, carry traders tend to operate mainly (but not exclusively) in public debt securities.

Carry trade is a fundamental mechanism for understanding the dynamics that drive global financial flows. Strictly influenced by countries’ macroeconomic data and by the variations in interest rates regulated by central banks, the carry trade often returns an accurate image of the perceptions of the markets and the adjustment mechanisms that regulate them.

Some examples can clarify the close link between current events and carry trade mechanisms. The United Kingdom currently has an interest rate of 0.75%, while Turkey has interest rates of 24.0%. The difference in the cost of money can be used by borrowing in pounds, at a cost of 0.75%, and by investing in Turkish lira, that pays interest rates of 24.0%. After obtaining a 24.0% interest, you can repay your debts in pounds and earn accordingly. The leverage effect makes it possible to multiply returns (and risks) by moving the multiples of one’s own capital on the market.

A cut in interest rates by the Turkish central bank can, however, put this strategy at risk: in this case, the increase in the price of bonds in circulation increases the returns by benefiting the carry traders who have them in the portfolio, but lower yields of newly issued bonds reduces the margins for those who want to apply the same strategy with the new Turkish debt securities. For this reason, traders look for the most stable exchange rates, the most reliable currencies and make frequent use of stop losses.

Is the gold rally going to continue?

The gold market is experiencing a consolidation which is deemed necessary by analysts, down from the last 6-year high, but many experts believe that the rally is destined to continue.
Gold prices came under pressure after Federal Reserve bankers tried to manage expectations before the next monetary policy meeting in July. Investor expectations for a 50 basis point cut in the next FOMC have declined since Governor Jerome Powell hinted that the central bank will not overreact to a short-term sentiment fluctuation. August gold futures were traded at $ 1,407.6 an ounce yesterday, down -0.28%. The question is whether the gold rally is destined to continue even in the coming weeks.
From a technical analysis point of view, gold must support the $ 1,380 threshold, a significant resistance over the past four years. On the upside, prices face an initial resistance of $ 1,485 and $ 1,585 an ounce, both representing critical retracement levels compared to 2011 highs.
The strength of gold appears to be justified by the context of falling global bond yields. Last week, the value of the global debt with a negative yield rose to a new record of $ 13 trillion. The combination of lower interest rates, falling bond yields and the potential for a weaker dollar are the main causes that can drive the gold rally forward.
Although the Fed is trying to manage expectations, Powell’s latest comments have not moved the big picture much: the market continues to expect expansionary monetary policy stimuli. The market firmly believes that the economic risks of the ongoing trade war between the United States and China will force the Fed to react more strongly and faster than it said.


The pound travels towards the semi-annual lows against the euro

The pound approached the low of the last 6 months against the euro yesterday, falling to 1.1141, in the wake of news related to Brexit, which sees former foreign minister Boris Johnson increasingly accredited to the succession of Theresa May as leader of the conservative party. An eventuality that traders do not like, especially due to the well-known positions of Johnson’s brexiteers, which has repeatedly hinted at how it could accept, in the absence of an agreement shared with the EU, favorable in any case to the United Kingdom, also a no Brexit deal. A scenario that analysts envision as extremely adverse to the British economy and the pound but which sees US president Donald Trump as the main supporter.

Even the governor of the Bank of England, Mark Carney, has once again stressed the risks of a no-deal Brexit, stating in front of members of the Westminster parliament that the central bank could be forced to undertake new measures, in the case of a Brexit of this type. Previously, however, Carney had also stated that the BOE is ready to raise interest rates in the event of a “smooth” Brexit. Statement that had immediately helped the GBPEUR to rise by about 40 pips. However, the ascent was only temporary. Immediately afterwards, in fact, the pound went down again towards the opening value of 1.1160. With a decidedly downside-oriented market mood, it is possible that in the next few hours the pound will fall to below half-yearly lows.

Bitcoin is not gold

In a recent paper published for Humboldt University, researchers Tony Klein, Hien Pham Thu and Thomas Walther wondered if Bitcoin has market characteristics that make it similar to gold. Based on the data available up to December 2017, the answer seems quite unequivocal. Bitcoin shows returns that have an asymmetrical response to market shocks, in tune with the trend of precious metals, is the conclusion of the three researchers. Price increases lead to increased volatility. Considering the extreme price increases observed for Bitcoin, this result is not surprising for them. In the Bitcoin markets, researchers observed a huge rally in 2017, which ended with an important setback. These periods of high volatility led to greater persistence.
As for possible links with financial markets, the correlation measured shows that Bitcoin behaves completely differently from gold, particularly in the bearish market phases. While the flight-to-quality property of gold is confirmed, Bitcoin shows a positive mating effect that decreases when markets are falling, in situations of shock. Moreover, the evidence shows that Bitcoin is not a hedge to be used to protect an investor against the risks of equity investments, even if this hypothesis should be better tested. Furthermore, Bitcoin as a resource does not resemble any other conventional asset, at least from an econometric perspective. The results also seem to apply to other cryptocurrencies in the short term.
Finally, the researchers believe that cryptocurrencies will remain highly volatile and will continue to be exposed to strong movements in both directions, as their future development remains very uncertain. The significant movement of cryptocurrency prices depends on several factors. First, cryptocurrencies will continue to experience sharp price declines as investors continue to take profits to the maximum. Second, regulatory decisions will have a strong impact on investor behavior. Currently, regulators are still evaluating how to tackle the cryptocurrency problem. Thirdly, in the face of recurrent cyber attacks, the cryptocurrency ecosystem will have to strengthen its security standard to be accepted by traditional investors.

Trading the EURUSD with fed funds’ implicit probabilities

A famous rule of the thumb in macroeconomics states that a currency tends to appreciate when interest rates applied by the domestic central bank increase and depreciate every time they fall. Empirical tests carried out on the historical series of the forex markets show how this assumption is true.

So how do you predict when a central bank will change its interest rate monetary policy? Let’s take the dollar. A useful tool is represented by the implicit probabilities of the fed funds published each day by the Commodity Merchantile Exchange through the FedWatch tool. The Fed Watch assumes that a probability of a rate hike is calculated by adding the probabilities of all target rate levels above the current target rate. Probabilities of possible Fed Funds target rates are based on Fed Fund futures contract prices assuming that the rate hike is 25 basis points and that the Fed Funds Effective Rate will react by a like amount. FOMC meetings probabilities are determined from the corresponding CME Group Fed Fund futures contracts.

The FedWatch tool calculates unconditional probabilities of Federal Open Market Committee meeting outcomes to generate a binary probability tree. CME Group lists 30-Day Federal Funds Futures futures, prices of which incorporate market expectations of average daily Federal Funds Effective Rate levels during futures contract months. The FFER is published by the Federal Reserve Bank of New York each day, and is calculated as a transaction-volume weighted average of the previous day’s rates on trades arranged by major brokers in the market for overnight unsecured loans between depository institutions.

A good strategy for dollar traders is choosing an investment horizon and see the implicit probabilities at the end of that period. By observing the related probabilities, a trader can see investors’ beliefs on the interest rate levels and go long/short with the dollar against other pairs. It is a medium term strategy which works especially under normal market conditions. Very rarely implicit probabilities are disattended by the actual FED’s decisions, when a probability is higher than 60-70%.

Using the COT Report to trade succesfully the EURUSD

One of the most profitable trading strategies has always been to follow the crowd, and mimic the positions of top investors. However, it is often not easy for small traders to have the information summarizing what big investors are doing. The COT report (Committments of Traders) certainly provides a very useful tool for obtaining this information.

Published every Friday by the Chicago Mercantile Exchange (CME), the COT report reports all long and short positions, in absolute terms and weekly change, and the spread, for different categories of investors. For the euro, these categories are: dealers, asset managers, leveraged funds (including hedge funds), other reportables and nonreportables. Dealers and asset managers represent investors who have a medium-long term investment strategy (strategic investors), while leveraged funds are those who have a short-term strategy (tactical investors).

From the analysis of the increase or decrease of long and short positions, it is possible to understand how investors are positioning themselves on the euro-dollar, or if they bet on an appreciation, rather than on a depreciation of the single currency against the greenback .

Example 1: a strong increase in long positions by leveraged funds, accompanied by a sharp reduction in short positions, suggests that this category of investors is betting on a euro appreciation against the dollar in the short term.

Example 2: a sharp decrease in long positions by asset managers accompanied by a sharp increase in short positions suggests a bet on a depreciation of the euro over the medium-long term.

Therefore, following what investors do and replicating their sentiment, captured by their committments, can be a good trading strategy. The empirical evidence shows the existence of a strong correlation between the COT positions and the actual performance of the EURUSD. Obviously, like any statistical evidence, it should not be taken as an absolute law.

Libra, cryptocurrencies and the limits of financial supervision

Money is all that is accepted as a means of payment. This is the first textbook definition that is taught in a normal university course of monetary economics. Money is therefore a social convention, which individuals accept and use, from a piece of metal to a printed paper ticket. For this reason, cryptocurrencies are in effect currency, as long as they are accepted as a means of payment by a community. A different question is the legality of money. In the modern economy, only coins with legal tender course can be used for transactions. Those not required by law, retain their role as currency but cannot be used in trade.
With the advent of blockchain technology, which has enabled the creation of a considerable number of digital currencies and that of social networks, which offer the possibility of creating a market of exchanges of unprecedented size, the world of currency and financial regulation is strongly questioned. The case of Libra, the digital currency that Facebook would like to launch as a transaction tool for its social network is the most striking example. The current technology allows you to use Libra and the demand for this type of currency exists and is huge. The constraint is only of a regulatory nature, since the main financial watchdogs have already put their hands on the risks associated with the use of this cryptocurrency, especially on the privacy side. The central bankers themselves have opposed the idea, denouncing its monopolistic character, pretending to forget that every central bank has a monopoly on the issue of money, imposed by the state, not by citizens.
Policy-makers may be delaying the use of cryptocurrencies, but the day will come when user demand will be too high for them to continue to be banned. Even the major financial institutions have understood this, so much so that the investment bank JPMorgan has already stated that it wants to launch its cryptocurrency in the short term. Jamie Dimon, its CEO is famously a libertarian, with an extremely capitalist and private market-oriented vision. Another forty major lenders are thinking of doing the same thing. The very fact that Bitcoin has remained standing since the terrible 2018, in which many now regarded it as a depleted bubble, shows that cryptocurrencies are much more anotable to the globalized digital market than many believed. For this reason, the assumption of a medium-term future in which the currency market will be entrusted to private entities, rather than central banks, is not utopia. The consequence of this is that the Forex market may be more populated with private currency than by fiat currencies.

From trade to currency war

The words of the US president Donald Trump addressed against the president of the European Central Bank Mario Draghi, accused of being a manipulator of the euro with the intent to obtain an advantage for the economy of the eurozone, risk causing an escalation of tensions able to transform the current commercial war in which the United States and China are involved in a global currency war, with central banks used as a weapon to devalue the domestic currency. On the other hand, President Trump would like the Federal Reserve to support its goal of weakening the dollar, to make US-made products more competitive.
Certainly, one of the main advantages of modern economic policy is having central banks independent of the executive power. The Federal Reserve and the European Central Bank are the best examples. Yet even this principle is now being questioned, due to the unprecedented pressure exerted by political leaders, who would like to see ultra-expansionary monetary policies, low interest rates and a high money supply. Also, and not least, to depreciate domestic currency against others, and thus obtain an advantage in terms of greater exports, considering that, in a globalized economy, penetration into other markets is one of the main key drivers to increase GDP.
Yet even the promise of monetary easing recently made by the two most important central banks risks producing limited effects on the economy and, consequently, on the ForEx markets. With governments increasingly indebted and almost zero spaces left to fiscal policies, the only remaining stance for politicians is to be able to count on a central banker who implements an expansive monetary policy. In the case of the US, this should make up for the ineffectiveness so far of the tariff policy, which has certainly not helped to reduce Washington’s huge trade deficit, as hoped by Trump himself. Or the big tax cut, the effects of which could be limited over time. So then, when you failed to increase the prices of other countries, you would now like to get lowered yours. The problem is that central banks do not pursue a foreign exchange target nor could they do so, considering how much ForEx markets are governed more by private than public variables. For this reason even the currency war, like the trade one, could result in a new stalemate for Donald Trump.

Will social networks be the bank of the future?

Yesterday, Facebook, the most famous social network in the world, said it was ready to launch its digital currency, named Libra, starting in 2020. The cryptocurrency will allow billions of users of the site designed by Mark Zuckemberg to make worldwide financial transactions. This is an important strategic change for Facebook, which is seeking to expand beyond social networking, e-commerce and global payments. Once Libra will be launched, users will be able to download Calibra, a digital wallet that will be available in Messenger, WhatsApp and as a standalone app.The challenge of Facebook is epochal. If the strategy were to really work, the network would almost certainly become the largest monetary transaction site in the world, at least for C2C, waiting to think about possible developments also for B2B. Not to mention that, at that point, other social networks could work to create their own currency, thus creating a competition between digital currencies that would take away space from traditional fiat currencies. At that point, from a digital commercial bank to a digital investment bank would be a short step. To make the social networks huge commercial banks become and then open up units that deal with investments, for more significant amounts. It would obviously be a revolutionary scenario for the entire global credit system. Social networks like banks, digital currencies instead of traditional currencies, maybe without central banks.

The problems, of course, are big. The first concerns the acceptability of such a system by the global financial establishment. As a de facto competitor to fiat money, Libra would be treated by central bankers and major international institutions – such as the Financial Stability Board – like they treat Bitcoin and other digital currencies currently in circulation, with which regulatory bodies have never been forgiving . Suffice it to recall the words by Mario Draghi or Mark Carney against cryptocurrencies. Libra’s acceptance by the supervisory authority is obviously not granted. Quite the contrary.

The second major obstacle is privacy. With Facebook already being targeted by authorities for various allegations of privacy violations, the introduction of Libra is already drawing the attention of financial regulators and privacy defenders around the world. Facebook is currently facing a $ 5 billion fine from the US Federal Trade Commission (FTC), which opened an investigation in response to the Cambridge Analytica revelation scandal reported for the first time by British newspapers Guardian and Observer.

US and British officials have expressed concern about Facebook’s entry into the financial sector. In May, members of the US Senate Finance Committee wrote to Mark Zuckerberg, asking him to answer questions about privacy and financial regulation. Facebook executives responded that the system will help many millions of people without bank accounts, who will be able to enter the banking world and send money more easily thanks to access from mobile phones.

Will PBOC abandon Yuan’s ‘Threshold 7’ soon?

There is a great paradox in the debate on the Chinese yuan. After stalling in negotiations between the United States and China to end the trade war, the exchange rate against the dollar has begun to weaken again, approaching that “threshold 7” that many Forex traders see as a psychological threshold.

The last time the yuan broke that barrier was during the 2008 crisis: since then the Chinese central bank has always intervened to stabilize the national currency, even at the cost of heavily depleting its foreign currency reserves.

The paradox lies in the fact that it is now the United States of President Trump that threatens Beijing to include China in countries that manipulate the exchange, asking the country not to depreciate the renmimbi, which is the same as manipulating it.

At the last G20 summit last week, US Treasury Secretary Steven Mnuchin said that the absence of an intervention on the exchange rate by the People Bank of China can be interpreted as manipulation if “the markets expect it and you did it for a long time”.

Clearly, it is in China’s interest to depreciate the yuan, since it would make its products cheaper on foreign markets, considerably limiting the effects of the tariff policy imposed by Donald Trump and restoring competitiveness to its businesses. The problem is that a depreciation would also cause capital flight to financial assets denominated in stronger currencies and undermine President Xi Jinping’s great project of making the renmimbi an international currency used in global trade, as an alternative to the dollar.

It is therefore possible that, if the trade war persists, Beijing decides to no longer respect the “threshold 7”, leaving the national currency depreciate with uncertain outcomes even for the USA.