Yen Crosses and the Carry Trade Logic (part 2)

The yen has for long stretches carried one of the lowest interest rates among major currencies. That single fact explains much of how the yen crosses behave. Borrowing in a low-rate currency to buy a higher-rate one is called the carry trade, and the crosses are where it lives.

The logic

A trader who is long the Australian dollar against the yen earns the rate difference each night, as long as the exchange rate does not fall. When conditions are calm, this steady income attracts capital, the cross drifts higher, and the drift attracts more capital. The trend feeds itself.

The weakness is in the phrase as long as. When fear rises, carry traders rush to close at the same time. The cross can lose in days what it gained in months. This is why yen crosses tend to climb a staircase and leave by the window.

Reading the crosses

Three forces drive them:

• The interest rate gap, which sets the direction of the drift
• Global risk sentiment, which decides whether the drift continues or reverses
• The yen itself, which can strengthen sharply when its own central bank changes course or intervenes

A cross can be rising because the foreign currency is strong, because the yen is weak, or both. Check the yen against the dollar to tell which, because the answer changes how the cross will react to news.

Trading them

Carry positions reward patience and punish leverage. Small size, wide stops and a long horizon suit the drift. Tight stops get hit by the frequent sharp dips. Traders who prefer short holding periods often do better trading the crosses in the direction of the day's risk sentiment and ignoring the swap entirely.

Whichever approach you take, respect the asymmetry. Upward moves are slow and downward moves are fast, so a trailing stop on a long position should be looser than instinct suggests, and a short position should be taken only with a plan for the slow grind against it.

What to watch

Watch the rate gap between the two currencies and any hint it will narrow, the broad risk mood as seen in equity indices, and the yen against the dollar for signs of independent yen strength. A sharp dip that recovers within a day is the carry trade shaking out weak hands; a dip that does not recover is the start of an unwind.