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Forex: USD/JPY And Carry Trade
6/21/2007 10:41:52 AM

By Vadim Pokhlebkin

If you've been watching the Japanese yen lately, you know that it has weakened significantly in the past two weeks. And yesterday (June 20), it dropped to its "weakest in more than four years versus the dollar and fell to near a record low against the euro." (Bloomberg)

The beneficiary of this weakness, in theory, has been the now famous carry trade, a popular way for big market players to take advantage of global inefficiencies. Carry trades came into being circa 1999, and they are not to be underestimated. Word on the street is that they are a big reason why global stocks have rallied over the past four years. And a sudden drop in their volume was rumored to be the reason for the global "mini-crash" on February 27.

Carry trade works like this: You borrow money from countries with a low interest rate and re-invest in countries where the rate is higher. A popular choice has been to borrow in Japan, where until late February the interest rate has been a measly 0.25%, and invest elsewhere, i.e. in New Zealand, whose securities currently yield over 7%.

But the trade works best under two conditions. One, there must be a sufficient interest rate differential between the borrowed and reinvested funds. And two, the currencies you borrow and re-invest must remain stable.

Both of these conditions are now under threat, say many analysts. The Bank of Japan plans to continue "gradually" raising rates, shrinking the interest rate gap between Japan and the rest of the world. And higher rates might strengthen the JPY, further discouraging carry traders. Some analysts expect the yen to strengthen to 118-115 JPY per USD in a matter of months. That's 6 to 9 figures below this week's USD/JPY high of 123.74. Big move.

Of course, everything you've just read is the fundamental reasoning. It assumes orderly, logical relationships between financial markets. However, as Elliott wave practitioners, we've seen a lot of evidence suggesting that forex markets don’t move based on logic alone – emotions play a huge role, too.

Perhaps that's why our present Elliott wave count for the USD/JPY is not nearly as bearish as the fundamentals may suggest. The latest weekly chart from our Currency Specialty Service suggests that the USD/JPY may be in a complex correction (likely a "triple zigzag") – and what's in store are higher, not lower prices:

Why do we believe that? Well, as our Chief Currency Specialty Service Analyst points out, despite all the recent gains, "it's been a long, long time since the USD/JPY has moved impulsively, in either direction. So I continue to view the rally from early 2005 as a correction [which is still] incomplete."


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Stay ahead of the action in these markets:

Dollar Rates Cross Rates

        EURUSD       USDCHF

                   EURCHF

        GBPUSD       USDJPY

                   EURJPY

        AUDUSD       USDCAD

                   EURGBP

             Dollar Index

 

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markets Close Change
Dollar Index80.44000.5300
Euro/British Pound0.87450.0034
Euro/Japanese Yen122.0800-0.1200
Euro/Swiss Franc1.46720.0030
US Dollar/Canadian Dollar1.0711-0.0032
Australian Dollar/US Dollar0.86840.0038
US Dollar/Japanese Yen89.26000.2200
British Pound/US Dollar1.5640-0.0116
Swiss Franc/US Dollar1.07240.0055
Euro/US Dollar1.3678-0.0046
Closing prices for 2/8/2010

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The Elliott Wave Principle is a detailed description of how financial markets behave. The description reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific Elliott wave patterns in price movements. Each pattern has implications regarding the position of the market within its overall progression, past, present and future. The purpose of Elliott Wave International’s market-oriented publications is to outline the progress of markets in terms of the Wave Principle and to educate interested parties in the successful application of the Wave Principle. While a course of conduct regarding investments can be formulated from such application of the Wave Principle, at no time will Elliott Wave International make specific recommendations for any specific person, and at no time may a reader, caller or viewer be justified in inferring that any such advice is intended. Investing carries risk of losses, and trading futures or options is especially risky because these instruments are highly leveraged, and traders can lose more than their initial margin funds. Information provided by Elliott Wave International is expressed in good faith, but it is not guaranteed. The market service that never makes mistakes does not exist. Long-term success trading or investing in the markets demands recognition of the fact that error and uncertainty are part of any effort to assess future probabilities. Please ask your broker or your advisor to explain all risks to you before making any trading and investing decisions.