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 Yen Carry Trades for Commodity Exporters
by Kevin Pendley
When most of us think about a faraway southern-hemisphere land such as Brazil, we romanticize the amazing Ipanema beach, or think about the spectacular carnival celebration every year in Rio de Janeiro. But Brazil has more to offer to the world than micro bikinis and the planet’s most amazing annual party. Many people are surprised to hear that Brazil is actually the fifth largest country in the world by population and is by far the largest Portuguese-speaking nation on the globe (sorry, Portugal).
From a commodity standpoint, Brazil is also one of the richest lands on earth. The GDP of Brazil ranks in the top 10 in the world, while agriculture and metals exports help secure a hefty trade surplus, underpinning the currency value. Warren Buffet — the oracle of Omaha, himself — famously said that he never would have believed he would invest in Brazil 10 years ago, but he is widely thought to have made a handsome return on his investments there in recent years.
In this column a few weeks ago, we explored the concept of trading FX to ride the runaway commodity express train. Since then, the Commodity Research Bureau Index has stormed to new record highs, as has the iPath GSCI Total Return structured note index fund, which tracks price direction in the commodities arena. As a major exporter of commodity goods, Brazil has benefited from the surge in commodities and stands to continue that trend as long as demand for commodity goods remains strong (here’s a hint: people have to eat, and they have to fill their gas tank).
Another strong commodity producer and export-driven economy is Mexico, which has seen a solid currency performance in recent months. The Mexican GDP actually ranks as the 12th largest in the world.
For newcomers to the world of foreign exchange trading, one often overlooked aspect is the interest rate differential between the countries where one is making a trading decision. Over the years, you may have heard about various “carry” trades and how hedge funds borrow money cheaply from one country to finance purchases elsewhere. The primary darling on the short side of carry trades is the Japanese yen, where money has been cheap to borrow seemingly forever.
In fact, current benchmark interest rates from the Bank of Japan are at 0.5%. Compare that with rates in Brazil, which are at 12.25%, or versus Mexico, where rates are at 7.5%. Brazilian central bank authorities this week stated that they will continue to raise interest rates to battle inflation amid a strong economy and commodity price advances. What this means from a currency standpoint is that if you buy the Brazilian real and sell the Japanese yen, you are gathering about 11.75% in annualized gain just from the interest rate differential. If the Brazilian real happens to appreciate in the process (here’s another hint: it’s up nearly 12% against the yen since March), then that just adds more of a juicy return to the trade, while providing a modest cushion against minor price decay. It should be noted here that the real/yen cross is not heavily traded, and it might take a little work to get a broker to execute the cross for you. You could also consider buying dollar/yen and selling dollar/real, which are more actively traded on the interbank market.
The peso/yen cross is more actively traded, and looking at the chart structure in the Mexican peso/yen, there is a clear inverted head-and-shoulders bottom emanating from the dramatic rise in prices off the March lows. This is a “buy dips” chart that appears to be gaining momentum for a run toward 11.5 resistance, which would be an appreciation of another 12%, not to mention the 7% interest rate differential in play. A slide back below the 9.7 area would endanger the immediate upside momentum.
As for the Brazilian real, it has been making historic highs against the greenback lately, which lowers purchasing power for tourists visiting the lovely beaches of Rio and means we could see quite a few more Portuguese-speaking visitors up here in the north soon. The real/yen price has also been in rally mode since March, surging off a great double bottom formation and is now at the doorstep of key resistance along the record highs just above 65. This looks like a potential triple top test, and my research shows that double bottoms are great reversal formations, but triple tops seldom hold. If the cross pops through to new record highs against the yen, then it could trigger another long-term move higher.
It’s hard to ignore the timing of this latest rally in the yen carry trades favoring the real and peso: both of these moves coincided with the rally in the U.S. stock market off the March lows. We are now in a pullback mode in stocks, so upside price action in these two export-driven currencies stands to stall if that correlation to U.S. stock market action remains in place. But even a pullback in the price component of these crosses is soothed somewhat by the favorable interest rate differential accrual.
To update our current trade recommendations, we got whipsawed on ECB chief Jean-Claude Trichet’s rate hike comments last week, getting stopped out of a short euro/dollar trade, but then the position was put right back on at our original entry when the euro did an about face on persistent inflation saber-rattling by Federal Reserve officials. I continue to prefer long-term short euro/long dollar exposure, and hope that those of you with less demanding stop orders are still short in the 1.5680 zone and now breathing easier.
FX COLUMN TRADE CONCEPT RECAP
DATE CONCEPT PRICE THEN/NOW PROFIT/LOSS COMMENT
4/24/08 Short euro/dollar entered @ 1.5682 +0.52% stopped out at 1.5600
5/01/08 Short euro/yen entered @ 161.50 +0.12% stopped out at 161.30
5/08/08 Short euro/Canada entered @ 1.5680 +1.46% profit taken @ 1.5450
5/15/08 Short euro/yen entered @ 162.40 -0.36% stopped out at 163.01
5/29/08 Short euro/dollar entered @ 1.5525 -0.55% stopped out at 1.5610
6/10/08 Short euro/dollar entered @ 1.5682 +1.72% stops @ 1.5610
Kevin Pendley has been involved in financial and commodity markets for two decades, including more than 15 years with Knight-Ridder Financial News/BridgeNews. In addition to his work at 4xAdviser.com Weekly, he is a contributor at SmallCapInvestor.com where he writes a weekly technical analysis column on the Russell 2000.
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