Let’s take a look at several groups who should be expert, and see how they really do. Take hedge funds to start. Over the last decade, their returns (according to Institutional Investor) barely exceed the market returns of 10%. And surprisingly, they’re not even that good! Consider survivorship bias. About 9% of hedge funds go out of business every year- 3 or 4 times the rate of mutual funds. The returns of dead hedge funds don’t get counted in the now too rosy record.

Really lucky and well-run mutual funds in good years (that is, years when the market matches their strategy) might make 15-20%, but the average 5 year return is 9%.

What about “Real Money”? This is the term used to refer to large pension funds, endowments and other expert managers of money. They are very good at diversification, often using 10-12 different markets to extract risk premia, balancing them right in a Markowitz efficiency frontier sense. They have large teams of researchers, and because of their size are able to demand the best terms of trade and narrowest bid-ask spreads. Yet they perform in about the same 10-20% return per year.

What makes a lone, new forex trader expect to beat large teams of experts? The science of behavioral finance tells us that we are subject to a number of rather embarrassing biases. Among them are Overconfidence, Confirmation Bias, Mental Accounting, Illusion of Control and Optimism. If you are not familiar with these concepts, I suggest you do a Google search to understand how our minds work in this space, because these fallacies fan the flames of outsized return expectations, and also lead to demolished accounts.

I am sure someone, somewhere, knows a trader who really did strike it rich, making winning trades 90% of the time with some special strategy. Remember survivorship bias – you aren’t hearing about the 99% of traders who blow themselves up, never to return to the game. And luck plays a part, too. As Nassim Taleb points out, if you did find that special monkey who types out Homer’s Iliad on his well-built typewriter, are you really going to expect he’s producing the Odyssey next?

It is very difficult to find trading strategies that reliably make money, especially big money. This just makes sense. If some incredible trading strategy was able to produce 100% every year, everyone would use it (which would diminish its effectiveness), and Goldman Sachs would probably own it and license it.

If you can generate a forex strategy which returns 10-20%/year regularly, you are doing fantastic, beating the experts and the markets by 2X.

Paul Stafford

4X Trader Tools.com

First, a review of what the carry trade is might be helpful. Carry trade is a strategy which takes advantage of the different interest rates in different countries. The difference can be dramatic, as this table shows:

Generally, the difference in interest rates can be traced to the differences in risk of default in each country. As you can see, the Brazilian Real, the Turkish Lira and the South African Rand top the list, while the US and Japan hold down the bottom of the risk and return list. I am sure an interesting correlation could be made between the interest rate and the Sovereign Credit Default Swap rate (exercise left to the reader).

Historically, the JPY was used to fund the carry trade, but now the dollar is also a very attractive funding currency. With few signs that the US will exit its loose monetary policies any time soon, it looks likely to remain so at least through next year. One effect of carry trade is that the funding currency is weakened as it is sold to buy the higher-yielding currency, which strengthens on higher demand. This is the effect that weighed on the JPY between 1996 and 1998, and again between 2001 and 2008. Much of hedge fund returns can be traced to the carry trade. The size of the previous carry trade phase could have been as high as $1Trillion

There are several ways in which to play the carry trade. One way is to exchange one currency for another, and then invest in risk-free securities in that currency, such as bonds, which will earn more interest than in the base currency. This is a little cumbersome.

Another method is to initiate positions in the Forex market. For example, when an investor goes long the AUD/JPY, he is short a currency whose central bank pays 0.1%, and long a currency whose central bank pays 3.5%. An FX market maker will either pay out (or as appropriate, charge) a carry interest, which is what the investor is interested in. It is not usually as simple as taking the difference between the central bank rates, as the market maker adjusts daily, takes a spread, and bases the rate on indices (such as Libor) that closely track the central banks rates .

The Forex method is more common because it is easier to utilize leverage to enhance the interest rate difference. Assuming for the moment that the simple difference is what is paid, a 1:1 position in AUD/JPY would pay 3.5%-0.1% = 3.4%/annum; not an especially interesting number. However, F/X carry trade investors can utilize a higher leverage such as 10:1, which would generate a return of 34%, a very exciting number. OK, what’s the catch? It’s simple- the risk of the exchange rate moving against the investor.

For example, the BRL might be seen as an excellent choice of currency to be long. In the period from 2003 to 2007 the BRL appreciated from 4.0BRL/$ to 1.6BRL/$, a 250% rise. Not only were investors getting an enormous interest rate differential, but saw the currency appreciate as well. However, if you initiated this trade in early ’08, the BRL dropped 50% in value, more than wiping out any interest rate differential. This risk can be mitigated in several ways.

• One way is to stick with the majors. Which the rate differentials are not as high, leverage can boost returns and the exchange rates don’t exhibit extraordinary volatility.

• A second way is to buy insurance. There are option strategies (eg collars) which limit the effects of exchange rate volatility, while allowing an investor to benefit from rate differentials. The cost of the collar is minor, depending on the leverage utilized. N.B this is also the tactic major import-exporters use to insure against F/X exposure, along with forwards.

An investor thinking of initiating a carry trade should line up all the macro ducks they can- twin surpluses (ie current acct and budget), purchasing price parity vs spot, GDP growth- etc. They should also manage risk by calculating the effects of exchange rate swings on the potential position, and potentially taking out insurance. A carry trade is truly a longer-term trade, as you need to hold the position for lengthy periods to maximize the interest return. However, this also increases your exposure to the drift in the exchange rate (as opposed to just the volatility). Also, there is a small but non-zero chance of a central bank devaluing a currency (eg Mexico or one of the Central and Eastern Europe (CEE) countries).

The carry trade may very well be one of the winning strategies in the next several years. Many of the higher yielding currencies-especially in the Emerging Markets (EM)-are set to appreciate more than the funding currencies of the majors ($, CHF, JPY).

Paul Stafford writes a weekly Currency Briefing, which covers fundamentals and sentiment measures for the major currencies. If you are interested in receiving it, please visit www.4xtradertools.com

Since almost everything we look at is valued in dollars, it is sometimes hard to separate the effects of a strong or weak dollar from real economic trends. For example, gold is hitting record levels vs. the $, and oil may finally punch through the $73 level. Are these real effects? Well, one interesting measure is the Gold/Oil ratio. Historically, it has hovered between 10 and 15. In February of 2009, it rose to nearly 30. Now it is back to about 14.7, or well within its historical range. If you look at gold vs. other currencies, it is not at historic highs- for example it remains 30% below its highs in AUD. In actuality, demand for commodities is still very low. Witness the “ghost fleet” of 500 freighters (20% of the fleet size) idled off Singapore due to lack of international shipping, or the Baltic Dry Index, etc. High commodities prices are simply the result of a weak dollar.

The S&P is now trading at a massive 27:1 trailing P/E ratio, and 140x trailing P/E on reported earnings. This is three times the levels of the tech bubble. I believe one reason (amongst others) is the depreciation of the dollar. Another direct indication is the $ index, now at 76 (nearly its 10 yr low of 72 in July of 08), and a far cry from its highs over 117.

We must ask- is this a low from which the $ stages a comeback, or just the beginning of a long term slide? I fear I must come down on the side of further depreciation over the long term.

• USA budget deficits will inevitably worsen due to lack of political will
• The inexorable move away from the $ as the reserve currency due to its mismanagement. This has already started (China, oil producers)
• Implicit monetary policy- the Fed will not move strongly against inflationary pressures
• Carry trade effects as other countries exit QE and raise interest rates earlier ($ becomes a funding currency)
• Sentiment- when markets lose confidence in a currency (witness the Pound when it withdrew from the ERM), sharp declines and high volatility will dominate

I always try to look for disconfirming evidence, and one positive element for the dollar might be an improvement in the current account deficit due to a weaker dollar driving exports. However, the continued offshoring of manufacturing, and import of energy argue against this having a large net positive effect.

This doesn’t mean that the dollar index will drop monotonically in the next 6 months or year. Exogenous events, black swans (think Iran and nuclear missiles aimed at Europe) can all reverse direction for many months. After all, the $ index reversed its decade-long decline from 117 to 72 back to 89 in only 4 months as risk aversion set in, in late 2008. But the future cannot belong to the dollar.

Paul Stafford is an accomplished investor, business expert, and trader. He  performs practical fundamental currency market analysis in his weekly “Stafford Weekly Currency Briefing” at 4xtradertools.com

USD JPY

Predictions abound that USD/JPY will continue to weaken since Japan may not support US assets at the same rate as before. The reasons for Yen appreciation against the Dollar are not entirely convincing yet. One must realize a lot of this is political talk and markets usually don’t change at the speed of political words- rather, they move fast when big positioning imbalances give out.

The fact that big exporters like Toyota weakened on the news isn’t good for the Yen. Any sustained Yen strength (i.e. below 90) is bad for the Japanese economy because it is still not out of the woods yet. Even though the party has expressed that it doesn’t care as much about the strong yen affecting the economy, the Ministry of Finance (who instructs the BOJ on whether to intervene) is an independent administrative institution.

It would be best to wait out this scenario to let traders show their hand. If price ventures lower and gets rejected, that’s a powerful indicator that not much force is supporting the Yen. Of course if there is a sustained downward push and the market has adopted this view, there may be a nice long-gamma, short USDJPY opportunity.