Carry Trade Could Explain EUR/USD’s Counterintuitive Moves
Matthew Weller | Jun 24, 2015 10:24AM ET
Traders the world over have been surprised by the relative resilience of the euro over the last few weeks, despite growing concerns that Greece may default on its debt and be forced to exit the Eurozone (the feared “Grexit”). Analysts have proffered various explanations for the EUR/USD’s durability: that the European financial system has had plenty of time to “ring fence” Greece and prevent contagion to other countries, that a last-second deal is imminent, or even that traders are just blithely underestimating the risk and damage of a Grexit.
One alternative explanation that we find particularly compelling is “Euro as a Funding Currency Theory.” As a reminder, the carry trade is when a trader borrows in (sells) a low-yielding currency and invests in (buys) a higher-yielding currency in an attempt to profit from the difference in interest rates. With the European Central Bank driving its main refinancing rate down to 0.05%, pushing its deposit rate all the way down to -0.2%, and engaging in large-scale quantitative easing, the euro represents the perfect funding currency for carry traders looking to borrow cheaply. Carry traders can then use these funds to invest in higher yielding currencies such as the New Zealand dollar, Turkish lira or even the Russian ruble.
However, as all experienced traders know, every strategy comes with risks and the carry trade is no exception. As a general rule, carry traders prefer low volatility and predictable risks, lest adverse movements in the spot market overwhelm any gains from interest rate differentials. Unfortunately, the Greece’s debt drama has neither of those features, and the increasing concerns about Greece have prompted carry traders to reverse their trades by selling higher-yielding currencies and buying back the euro, even though the source of risk (Greece) emanates from the Eurozone itself.
The “Euro as a Funding Currency Theory” hypothesis succinctly explains the counterintuitive moves we’ve seen in EUR/USD over the last few weeks. When it looks like Greece and its creditors are making progress on a deal, carry traders pile back in to sell the euro (as we saw earlier today ), the euro sees a seemingly implausible rally. This theory also has empirical data to support it: though there’s no precise statistics on the prevalence of the carry trade at any given time, we have seen a dramatic reduction in euro short positions in the CFTC’s Commitment of Trader data over the last few weeks, confirming that many traders have reversed previous short positions in the single currency.
…So What's It Mean For EUR/USD?
Of course, this thought process only matters insomuch as it helps traders capitalize on market moves. In that vein, traders who anticipate an agreement between Greece and her creditors by the end of the month, even if it’s another last-second, kick-the-can-down-the-road type deal, may want to position for a possible fall in the value of the euro as carry traders resume selling. The key support level to watch near-term is 1.1100, which has put a floor under EUR/USD month-to-date. Conversely, readers who think “this time is different” for the small Mediterranean country should be wary of a possible rally through 1.1400 resistance in EUR/USD.
Get The News You Want
Source: FOREX.com
For more intraday analysis and market updates, follow us on twitter (@MWellerFX and @FOREXcom)
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.