Buy This ETN to Profit from the “Carry Trade”

On Wednesday, China’s central bank increased interest rates for the fourth time since October. The European Central Bank is expected to follow suit.

Central banks increase interest rates when they want to slow down an economy that may be overheating and generating too much inflation.

There is already a growing perception that we’re nearing the end of quantitative easing and related monetary stimulus. But the central banks’ rate hikes reveal a new commonly shared sentiment: fear of inflation.

Essentially, it is a huge tectonic shift in the fundamental forces that move currencies. For traders and investors, it’s also a great opportunity. When a central bank changes interest rates, it creates an imbalance in capital flows. Those imbalances ripple through almost every currency traded.

As you know, money flows to where it is expected to get the best return. Obviously, it gets the best return in countries with higher interest rates. But it also helps if there’s anticipation of more rate increases in the future, creating even more demand for the currency.

This is due to the “carry trade,” where investors sell or borrow currencies with low interest rates and use that capital to buy currencies with higher interest rates.

The carry trade was a very big deal just a few years ago. The endless Japanese recession spurred its central bank to keep interest rates at rock-bottom levels. So borrowing yen to invest in higher-yielding currencies was an almost guaranteed way to make money.

That all changed in 2008, however, when the global financial crisis hit. Not only did other world banks start lowering their interest rates — making the carry trade less profitable — but borrowers also had to repatriate their capital to pay off bad debt.

Today, with central banks raising rates, the carry trade looks ready to make a comeback. As a trader, you’ll need to know when it has begun in earnest… and how to participate in this powerful force.

Luckily, monitoring the carry trade is easy. Just watch the iPath Optimized Currency Carry ETN (NYSE:ICI). This exchange-traded note (similar to an exchange-traded fund) uses the carry trade as an investment discipline. Any gains in ICI reflect a strengthening carry trade.

From a technical perspective, ICI is now forming a triple top at $47 — a key indicator. If it breaks above this price, it’s a clear signal that the carry is back!

Now, how do you prepare for it?

First, the Japanese yen will once again be a good target for carry traders. The terrible earthquake and tsunami sparked sudden yen buying — which is bad for the carry trade — but that was a temporary psychological reaction. With rebuilding a priority, Japan favors a weaker yen, and the G7 nations agree, taking action to keep the yen from gaining value.

As a result, the Australian dollar/Japanese yen (AUDJPY) and euro/yen (EURJPY) crosspairs will receive the benefits of bullish sentiment.

Also, if G7 rates continue increasing in the coming months, the Brazilian real will become more vulnerable to a sell off. Even though Brazil’s interest rates are at an astronomical level of 11.75%, a change in its differential with other currencies may be the tipping point for weakening this currency.

Let’s not forget the U.S. dollar. It is still a low-yielding currency and may also suffer from the carry trade effect. In other words, traders may push the dollar’s value down as they sell greenbacks and purchase other currencies.

But that’s a very tentative situation. If Fed Chairman Ben Bernanke signals that quantitative easing is not likely to be extended, or signals vigilance on inflation, traders may anticipate a rate hike.

The topic is already on the Fed’s mind. In fact, you can see it visually in a fairly new type of analysis called a “word cloud.” Simply put, I took the text of the Fed’s meeting minutes from March and used special software to reveal patterns in the document:

Clearly the word “inflation” came up a lot… and that doesn’t bode well for low interest rates. Still, we won’t know for sure until the next Fed meeting.

So for now, the best bet is to keep an eye on the ICI, anticipate a falling yen and watch the Brazilian real very closely.

These moves could make a huge difference for long-term currency investors.

Sincerely,
Abe Cofnas
Penny Sleuth

Buy This ETN to Profit from the “Carry Trade” was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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