*Please note (April 6, 2007): Oanda has recently updated their interest rate spread for the USD/CNY pair, it now yields 4.425%, instead of the previous 5.925%. While this does make this trade a little less attractive, using it in the carry basket should still provide substantial income generation over the next year.
As mentioned in my previous post in regards to the New Turkish Lira being the top currency choice to hold long in a carry trade portfolio, my new short position choice is now the Chinese Yuan. The FOREX broker that I use, Oanda, is currently offering an interest rate of 5.925% per annum to traders who hold the USD/CNY long, meaning long USD and short CNY. Even though the Chinese Yuan is currently being allowed to appreciate by its government, the Yuan has only appreciated against the dollar by about 3.6% over the past year. It is not in the best interest of the Chinese government to allow its currency to appreciate greatly against the other world currencies, especially the US Dollar, because of China’s dependence on exports.
All the talk over the past few weeks has been about the carry trade implosion when Japan announced and put into action its end to the 0% interest rate policy. Over the past few days, all the talk has shifted to the Swiss Franc because investors are now looking for an alternative to keep the carry trade going. What I think people may miss is the tremendous versatility that the Chinese Yuan offers to investors because of its predictability. Also, there are very few external economic factors affecting the Yuan right now; obviously everyone knows that it is undervalued, but since the Chinese government is controlling the value of the Yuan, the appreciation can be easily monitored.
The Chinese Yuan also offers much less volatility than the Japanese Yen and the Swiss Franc despite the economy being considerably less “established” in the minds of traders. Thus, traders continue to overlook the Yuan because it is seen as an Exotic/Emerging Currency and it is in the process of being appreciated in value. Appreciation of a short currency is seen as the one major factors that can make a carry trade turn sour, but, as mentioned, the likelihood of the appreciation of the Yuan surprising investors is quite doubtful. I, personally, like the Chinese Yuan over the Yen and Franc mainly due to the fact that I don’t have to deal constantly with the psychological effects of volatility and its effect on my account via the use of leverage.
Below is a chart showing the interest rate spreads for pairs and synthetic pairs utilizing the Chinese Yuan as a carry (in highest spread to lowest):
TRY/CNY: 18.00%
ZAR/CNY: 9.50%
INR/CNY: 8.75%
NZD/CNY: 8.50%
MXN/CNY: 7.50%
AUD/CNY: 7.00%
GBP/CNY: 6.25%
USD/CNY: 5.925%
CAD/CNY: 5.00%
EUR/CNY: 4.65%
The interest rates were calculated based on the Oanda Interest Payment Calculator. A useful tool I recommend is Google Finance and their currency graphing tool. Although the data only goes back to 2005, you can view synthetic currency graphs, such as TRY (New Turkish Lira)/CNY or INR (Indian Rupee)/CNY, which can give you an idea of the volatility and movement of the synthetic currency pair. (Yahoo Finance also has a currency graphing tool, but obtaining a graph on some pairs is not possible.) To view the currency pair, just type in the search field the first three letters of the two pairs you want to compare; for the TRY/CNY, you would type TRYCNY into the field and click “Search Finance”. I found this to be an extremely valuable tool in getting a visual of synthetic pairs that I came across in my research.
While the yields are pretty impressive by themselves, the ability to utilize leverage to multiply those returns makes them extremely attractive to a carry trader. While using the USD/CNY pair will only allow you to leverage 25:1 since Oanda considers it an exotic pair, I would not recommend going more than 10:1 for long-term trading, especially for carry trading. At first, It may be impressive to leverage your account enough to generate 100% returns each year from interest, but the probability that you will receive a margin call is pretty high. The key is to being successful in the FOREX market is money management, though I am sure any trader is attracted to the possibility of being able to leverage $400 for every $1 in their account. I know when I first started I was mesmerized by the dancing dollar signs floating around in my head, but as any experienced FOREX trader will say, you are quickly brought back to reality. While 1,000% returns are possible, the feasibility of achieving that is very small, and even the viability of generating 15 pips a day is an incredible hurdle.
The secondary purpose of this post today is to say that it is perfectly acceptable to expect a return of 10% to 20% a year (interest +/- currency movements), and my belief is that such a goal is pretty attainable. I know that is a far cry from the 100%+ returns that we are bombarded with each and every day online from ads, but the fact remains, because of being conservative, after 5 years of approximately 15% returns, hopefully we will have doubled our outlay, while the others will have lost 100% of their investment.
While the carry trade is definitely not the “Holy Grail” to FOREX investing, it does allow traders to follow a plan and operate on a “set and forget” type of strategy. Most FOREX traders work a day job, and they see FOREX as an investment, not as their livelihood, so this type of strategy is perfect for them. The key is to remain on the lookout for opportunities, because while the media reports on one subject, it is up to you to identify the prospects that are unseen. The Chinese Yuan is one of those opportunities that is often overlooked because the media has portrayed its appreciation as relentless. As my analysis has shown, it really has only appreciated by 3.6% over the past year (and I will predict this to continue, because that appreciation is roughly equal to the US inflation rate). The carry trade is alive and well, even if it doesn’t lie in Japan or in Switzerland.
