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Home » Uncategorized » About The Overnight Carry Trade Implosion: Basics

About The Overnight Carry Trade Implosion: Basics

We had an interesting trading session across FX, rates, metals and equity indices today. With the reversal of the Yen’s direction, we can clearly see what is moving the equity markets, in particular, but risk assets, in general. If you are not familiar with the carry trade convention in the foreign exchange markets, then allow me to inform you:

The carry trade is a foreign exchange transaction whereby an entity buys a higher yielding currency, while selling the lower yielding currency. That is, the entity receives an interest rate differential, the rollover rate of interest, for holding the higher yielding currency while funding the transaction with a lower yielding currency. The rollover interest rate for each currency is based on the overnight rate for the respective country that the currency is tied to.

What does this mean to equities, or risk assets across the board? It is rather simple really: entities obtain leverage on collateral to conduct said carry trade, on margin of course. Therefore, when you see the USDJPY pair going negative it should be no surprise to you to see SPX going red as entities are exiting USDJPY longs by selling equities, for example. You can look at this via any other major currency pair that contains the JPY as the quote currency; i.e. the currency that is being sold.

Why does this matter? I think it is simple enough to understand and believe that an entity needs currency to conduct any transaction in any market. There should be nothing to discuss in that respect. Therefore, an entity that is looking to purchase assets in equity markets, whether in the US, GB, DE, AU, etc, will need to obtain the respective currency to attain said equity. With respect to the US Treasury markets, it is plain to see that when the USDJPY pair sells off, entities are looking to purchase their collateral back; i.e. US Treasury’s. Hence, the price action in relation to those instruments in the market.

I hope this sheds some light into the bigger and more realistic picture of how markets actually work. Thanks for reading.

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