Lots of markets are exploding tonight, but one I’d like to point out is the Australian Dollar. It’s getting crushed.
The Australian Dollar has going up, up,up for a long time due to the Carry trade. The carry trade is where currency traders buy a currency that yields a high interest rate and sell a currency that costs a low interest rate.
This trade is typically done with decent amounts of leverage. So if you add in the gains from the interest rates to a little bit of appreciation in the high interest currency, the gains can be quite large.
The AUD interest rates are much higher than U.S. interest rates – so this trade has been a huge winner from the long side for the last year.
It’s a hugely popular trade.
The problem with the carry trade is when it unwinds, it happens in a few days. The currency falls off a cliff.
You can be stuck with a position that’s very hard to exit – and it wipes out the gains for the entire year.
It looks to me like the unwind in the AUDUSD is happening as I write this. Australian Dollar September futures are trading under 1.0000 at .9958
The AUDUSD blewout in May 2010 for 13% in just a few days. I expect this blowout to be larger, because the trade is over. The AUDUSD carry trade won’t come back because the RBA – Australia’s Fed – is likely to start cutting rates in a last ditch effort to shore up their housing markets.
As trendfollowers, we’re not hugely concerned with the exactly what is happening in the market. But it helps to know the dynamics of other large trades like FX carry trades – it can save you money during rough times because you’re more prepared for large moves like the one we see in the Australian Dollar futures.
Of course, our system was short from a few days ago. Who knows what might happen over the next few days and weeks?
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Michael Sankowski spends a lot of his time applying quantitative mathematics to financial markets. When he's not playing the guitar, he has been a professional trader for 20 years. He's traded billions of dollars on four continents and is a well-known financial writer. He's a CFA, CAIA, and has created patented Futures products. He's here to help you make more money (and especially not lose your money).
