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Greenback promises red-hot returns

Created:

11 November 2009

Written by:

Dominic Picarda

It's all about the US dollar. The biggest - and perhaps the only - game in town right now is borrowing for next to nothing in the American currency and putting the proceeds into pretty much anything that offers a higher return. Over time, this simple little technique - known as the 'carry trade' - has paid for countless hedge-fund managers' Ferraris, yachts and mansions.

When the carry trade works well, as it did with the yen for many years, it seems like easy money. Speculators secure funds at rock-bottom interest rates in the currency in question and usually channel those funds into the hottest areas of the day, like stocks or commodities. This further pushes up the things they invest in and drives down the currency they borrowed in, giving carry-traders a double-treat.

Eventually, though, every carry trade comes to an end. All of a sudden, investors want or need to liquidate the positions they've taken and repay the loan in the original currency. So the risky assets they bought with it go down, and the currency they borrowed in goes up, often dramatically so. Nouriel Roubini - an economist who foresaw many of the problems of recent times - predicted last week that today's dollar carry-trade would also come to a particularly sticky end.

If Professor Roubini is right, therefore, all investors should be keeping a close eye on the US dollar, whether or not they actually trade currencies. For those that are willing to trade or invest in currencies, the US dollar could represent an excellent strategic opportunity.

By most measures, the US dollar is cheap right now. Economic theory says that the dollar is about one-third undervalued compared to the Euro. That isn't to say that this cheapness will not persist for longer, or even become more extreme. Ultimately, however, history says that a strong move back towards fair value is likely to occur.

One way of playing the turn in the US dollar when it arrives is via the US dollar index. This index represents the dollar's performance against a basket of some of the currencies of America's important trading partners: the Euro, Japanese Yen, the Canadian dollar, the British Pound, the Swedish Krona and the Swiss Franc. The Euro exchange rate is the most important constituent - making up more than half the index - while the Swiss Franc accounts for less than 4 per cent.

The index is tradable as a futures contract, or for smaller traders as a contract-for-difference or spread bet. Currently, the index trades at a price of around 75 - not far from its all-time lows of last year of 70.32. At its strongest point during its last major up-cycle in early 2002, the dollar was as high as 112 - some 50 per cent above its current level.

If you trade the US dollar index via a spread bet, there is no daily financing charge, as all the costs are paid via the difference between your buying and selling prices. Your position will automatically expire on a set date in the future, although you can keep it open by rolling it into the contract with the next expiry date.

So, how far might the dollar index appreciate once its current sell-off ends? Elliott-wave analysis implies that from the bottom, it could easily rise by 42 per cent in its next major bull move. The next issue is when this terrific surge may begin.

The structure of the dollar's leg down since June is typical of a move in its late stages. That said, however, it would not be surprising if the biggest carry-trade of all time pushed the US currency down even further than everyone expects. A drop through last year's all-time low could either trigger panic-selling or mark the moment of absolute despair before the turn. Once that turn comes, though, it is likely to be decisive and unmistakeable.

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