Right now, there are a segment of currency traders called “carry traders” who are grappling with the future of their longer term position trades.
Carry trades are when investors buy a high yielding currency while at the same time selling a low yielding currency to essentially fund the trade. They earn the interest differential each day at 5pm EST.
Why do they worry now? Because the health of the carry trade is based off of a low volatility environment that is at least stable and hopefully has rising stocks and rising interest rates in the future, too.
This is where it all gets tricky. Stocks have risen ever since March and volatility has declined. So, between now and then, it’s been a no-brainer.
However, if stocks have gotten ahead of themselves, that’s worrisome to the carry traders. You see, if stocks fall, many carry trades will too.
One thing that concerns these currency traders is the lack of volume in the stock market’s uptrend lately. You see, a trend direction in stocks (whether up or down) is typically followed by an increase in volume.
So far, I’ve never seen a sustainable uptrend without expanding volume in the direction of the uptrend.
One thing’s for sure. It takes a mass of buyers to take stocks higher, but stocks can fall easily just due to a lack of volume.
So what we’re experiencing right now is like an airplane that is climbing in altitude and shuts off its engines. Oh sure, it may still go up just a bit longer, but if the engines don’t come back on gravity will take hold and take the plane to the ground.
It is possible that once the trading desks are fully staffed after the Labor Day holiday week that stock volume could pick up considerably. If so, then we could be out of the woods — if significant buying volume returns.
If not, expect a sizable correction in stocks, most commodities and therefore many currencies too. If this were to happen, then money would run to the defensive posture of the yen and dollar and away from high yielding currencies.
So watch this barometer of the stock market to see where the carry trades like AUD/JPY, NZD/JPY, and NZD/USD go from here. It won’t be long and these carry traders worries will either be over, or they’ll get their worst nightmare.
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