For carry trades, the most important question to ask is, “Where are interest rates headed?” The carry trades that are likely to profit in the future are not necessarily the ones that already have high interest rate differentials, but rather the ones that are setting up to have increasingly higher interest rates going forward. The USD/JPY currency pair fits this description perfectly.

Since June 2004 the U.S. Federal Reserve has increased interest rates by 250 basis points, from a 45-year low of 1 percent to the current rate (as of July 31) of 3.25 percent. The only other major countries with tradable currencies that have increased interest rates this year are Australia and New Zealand — and they have hiked rates only once this year, compared to four times for the U.S.

The U.S.’s campaign of aggressively raising interest rates has led to a sharp dollar rally since the beginning of the year. It illustrates the strength of the dollar rally: USD/JPY has soared more than 1,000 pips (points) since January; against the Euro, the dollar has rallied 1,600 pips.

There are many ways to explain this rally, but the most important catalyst is interest rates. The U.S. dollar went from being one of the highest-yielding currencies in the world during the Internet boom (with interest rates as high as 6.5 percent in June 2000) to one of the lowest-yielding currencies in the world when interest rates were subsequently slashed to 1 percent. This caused a huge flow of money out of dollar-denominated investments, a phenomenon that was exacerbated by capital leaving the U.S. following the tech collapse in 2000.

Many hedge funds and speculators at the time sold the dollar, hoping for widening interest rate differentials between the greenback and other currencies. These traders made out very well: Most carry trades, such as the AUD/USD and NZD/USD, appreciated more than 35 percent in less than two years. Over the past year, the same speculators are covering their short-dollar trades, hence causing the dollar to rally strongly.

In the case of the EUR/USD, the currency pair went from offering a positive interest rate differential of 1.25 percent in March 2003 to now offering a negative interest rate differential of 1.25 percent. This provides a perfect reason to explain why those who were long the EUR/USD as a carry trade have either closed or reversed their positions. With at least two to three more interest rate hikes expected from the Federal Reserve (while most other central banks are expected to do nothing), the dollar is still being supported by traders looking to go long the currency pair for carry.

The yen is the perfect currency to short vs. the U.S. dollar in a carry trade because of Japan’s zero interest rate policy. In fact, the yen happens to be the favorite currency for traders to sell against in a carry trade because for the most part, traders are paying next to nothing for borrowing the currency. The Bank of Japan (BOJ) continues to stand pat on rates. With mixed growth and deflation still a reality at this point, the BOJ feels no urgency to raise rates and threaten Japan’s still feeble economic recovery. This is especially relevant in the current environment of skyrocketing oil prices. Japan imports 99 percent of their oil (the U.S. imports about 50 percent).

Their lack of domestic sources of energy and their need to import vast amounts of crude oil, natural gas, and other energy resources make them particularly sensitive to changes in oil prices. If crude continues to rise, it will sap global demand and weaken purchases of Japanese exports. If oil prices remain firm, the yen should continue to sell off, which would be very beneficial for USD/JPY carry traders who are looking for both increasing interest rate differentials and capital appreciation.

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