EURMXN: Why the carry trade is back
As implied FX volatility (vol) falls and risk sentiment improves a touch, traders are seeking payment to be in a position, with the carry trade staging a strong comeback. My personal preferred carry vehicle right now is EURMXN, given the high swap received for being short this pair.
The EURMXN daily chart shows a gentle grind lower over the last week as the MXN has appreciated against the euro, a move that will be further exaggerated if the carry trade gains popularity. The pair is trading at a lower level not seen since mid-March, just before the pandemic sell-off.
The MXN is strengthening here not because markets like domestic economics in Mexico, but because the MXN is a high-yielding currency and traders are seeking profit from interest-rate discrepancies through the carry trade.
Emerging market (EM) currencies are extremely sensitive to global risk appetite, and we’re closely watching the US-China relationship, but markets are comfortable with MXN appreciation here while global risk appetite improves. But if risk appetite rolls over, so too will high-beta currencies like the MXN.
A solid gage for risk appetite is the S&P 500. If this world-favourite index can break the 3000 level, we should see a boost to risk sentiment. If price can’t break above and pushes lower, that will tell us global risk appetite is rolling over and we’d expect EM currencies to decline too. Also note that equity volatility remains fairly high, so a big move here would lift FX volatility.
The carry trade
The carry trade appeals when implied volatility is low as traders are paid a swap rate to be in a position, and can profit off interest rate differentials even if the exchange rate barely changes. Of course, the trade will run at a loss if the exchange rate moves against your position. Swaps are paid/charged daily Monday-Friday on rollover at 12am server time.
To be paid in a position, traders go long a high-yielding currency such as the Mexican Peso (MXN), currently with a 5.5% interest rate, while funding the trade with a low-yielding currency such as the EUR or GBP.
Generally, the higher the interest rate differential, the greater the swap rate. You can find swap rates on MT4 or MT5 in the Market Watch section by right-clicking the symbol and hitting specifications. In cTrader, search the symbol’s name and and click the information icon.
Central banks have suppressed implied FX volatility through global coordinated expansion and near zero-rates. While many are tapering QE programs, most remain open to further expansionary measures, including negative rates.
Chart of the Day: AUDNZD hits 5-month high in strong AUD comeback
We’re a long way from parity now as AUDNZD moves to a 5-month high in what has been a volatile ride for the risk-on currencies. Price action on the antipodean cross shows that traders expect the AUD to recover stronger and faster than the NZD
The AUDNZD pair has found resistance at 1.0625, which was also a key resistance level from December 2018 - May 2019. Zoom into the one-hour chart and you’ll see price action tried to push above this level several times overnight before briefly breaking above early in the asian session (02:00 server time). The pair has pulled back since as the 1.0625 level shapes up as one to watch. A daily close above here will indicate continued AUD strength relative to the NZD and give legs to a move higher, which could take us through to 1.0660.
The 5 EMA (green line) is currently at 1.0573 and offers a natural support level as it did for the rally from April 8 to 17. If the pair pushes even lower, the 200MA offers additional support around 1.0150.
It’s a powerful recovery for the Aussie compared to its kiwi counterpart after both currencies faced steep declines during the March sell-off, briefly trading at parity for the first time ever. The AUD fell faster than the NZD but is recovering much stronger.
The AUD is holding above 0.63 US cents, closing on the day at 0.6321. NZD remains below 0.60 US cents, closing at 0.5953 yesterday.
Both central banks dovish, but RBA less so
AUD bulls were encouraged to take the pair higher this week on expectations the Reserve Bank of New Zealand (RBNZ) will be more dovish than than the Reserve Bank of Australia (RBA). Since the crisis began, both central banks have embarked on quantitative easing (QE) programs but the RBA has significantly slowed its daily asset purchasing, expecting QE to be wound up sooner rather than later. The door has been left open to more if needed. Meanwhile, the RBA has ruled out negative rates but RBNZ Governor Adrian Orr has not. Both countries maintain a cash rate of 0.25%.
A stronger AUD recovery
China’s economic recovery is an important influence for AUDNZD. The New Zealand dollar’s exposure to China is in the agricultural space, and weighted at the premium end of the scale. This is a vulnerable position to be in as consumers tend to shy away from premium goods after an economic shock. Compare this to Australia’s raw material exports, which will be sought after sooner as industrial production in China ramps up again. The Aussie should bounce back stronger and sooner than the kiwi will. Trading the AUDNZD forex cross lets traders capitalise on discrepancies between the currencies.
The South African rand (ZAR) has fallen to a record low after the country’s debt was downgraded to junk status, exacerbating virus-induced weakness. Further ZAR weakness is expected and price action remains within an ascending channel.
USDZAR gapped higher (ZAR weakness) this morning, responding to the ratings downgrade, and surging past the 2016 low of 17.8775. USDZAR respected this level as resistance last Monday, whereas now the level is forming as support. Today’s second 4-hr candle looks as though it’s shaping up to confirm 17.8775 support has become resistance.
Price remains within the ascending channel that started 28 February, marked on the chart above. USDZAR bounced off the bottom of the ascending in Friday’s session. Rand weakness in light of the ratings downgrade is consistent with the expected move back to the top of the ascending channel.
Why the junk rating?
Moody’s Investors Service cited constraints to economic growth, including an unreliable electricity supply, poor business and investment confidence, and structural weaknesses in the labour market. Moody’s was unconvinced that the February budget would be able to turn around a deterioration in public finances.
Emerging markets (EM) reflect global risk appetite, and the speed at which these currencies have weakened shows the magnitude of global de-risking and USD strength during the COVID-19 crisis.
The ratings downgrade has exacerbated the ZAR’s virus-induced weakness.