A New Carry Trade in Europe?

Finally, We Have a New Carry
Trade in Play - in Europe

By Sean Hyman

Merry Christmas Currency Traders!

I haven't been able to say this in forever...but at long last, a carry trade currency is making a comeback!

And for once, I'm not talking about the Japanese yen carry trade. Nor am I talking about the other traditional low-yielder, the Swiss franc.

Instead, it involves the dollar.

This carry trade is a European exotic currency that's been beaten to a pulp this year - the Turkish lira.

So why is the Turkish lira carry trade coming back? In short, the risk-taking currency traders are starting to inch their way back into the currency markets. As a result, a few carry trades are already starting to benefit, including the Turkish lira.

Let's take a look at the chart below of the USD/TRY pair. (Remember, that as the pair goes downward, the lira is strengthening against the dollar.)

The Turkish Lira Finally Turns Around!


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Why in the world would an emerging currency like the lira make a comeback? Aren't all exotics getting massacred right now? Yes, many are - but there's reason to believe that the lira could turn a corner in 2009.

As you can see on the chart above, the lira has sunk like a rock for months now. However, if you take a closer look at the technical indicators in the graph above, you'll see that the lira has actually traded sideways (double topped) and broken through the dollar's strangle hold. This tells me that the lira is regaining its luster now.

You see, when the Fed cut rates to a range of 0% to 0.25%, they exposed a large yield differential between the U.S. and Turkey. Even with Turkey's recent rate cut of 1.25%, the lira still gives you a 15% interest rate. That's huge.

With the Fed's lower rates, you can ride the trend that's finally working in the lira's favor. Plus, you can earn carry trade interest while you hold this pair - hard to resist right?

You see, Turkey still has an annual inflation rate of 10.8%, so even if Turkey's central bank does slash rates further, Turkey will still offer a nice yield differential to other currencies. And it's true: They could cut rates further. But right now, the country is also facing some serious inflation, so this tells me that Turkey can only cut their rates so much.

So why did they lower rates in the first place if inflation was so high? Well, they have to balance growth with inflation. You see, growth crept at the slowest pace (0.5%) since Turkey emerged from the financial crisis in 2001. So Turkey's Central Bank was doing a balancing act there.

After all, they are taking some serious measures to help their economy. For instance, on December 5th, the Turkish government lowered the reserves that banks must deposit against foreign currency accounts to 9% down from 11% previously. In doing so, they freed up US$2.5 billion to lend out to consumers and businesses.

Keep in mind that the number is actually a lot larger than that because central banks always allow their banks to lend out far more than they actually have in their reserves. For instance, the U.S. can lend out about 10 times deposits roughly.

So lowering reserve requirements is a huge step in the right direction to boost growth by allowing more money to be lent out.

However, do keep in mind that this pair is also the king of volatility. So don't put on big positions in this pair and think that you will be able to stay in the trade. No, put on very small positions in proportion to what you normally do so that you can ensure yourself that you can stick around to collect that seriously high daily interest.

Next Stop on the European Exotic tour....Hungary!

It's true that the forint has been badly beaten in 2008. (In fact, my colleague Jack made a nice 1229% gain shorting the forint earlier this year.)

But now it appears the forint actually may take a turn for the better in 2009. I'm seeing bad data, but an improved currency.

Let me explain. For the better part of 2008, things have not been pretty for Hungary. Hungary has had ever slowing industrial production and the country's GDP fell 0.1% from the previous quarter.

The country even had to borrow 20 billion euros from the IMF, the World Bank and the European Union in October just to avoid a default. The Hungarian government expects the country's economy will contract in 2009 as Hungary's Eastern Europe trading partners import less of their goods.

They've even gone from a trade surplus to a trade deficit since October. So with all of this bad news, Hungary will likely have to continue to lower rates.

So why in the world could any of this be bullish for the forint? After all, its gaining strength on the dollar as you can see from the chart below.

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Everything But the End of the World Is Already Priced in the Forint!

The answer lies in the fact that the forint fell so far, so fast, that you can already see all this horrible data showing up in the forint's price. (In fact, I think they've priced in just about everything short of a nuclear war at this point.)

Everyone knew things were bad and they were pricing in the forint for the worst. It was a "sell it first and ask questions later" mentality.

However, they now have financial backing from all over the place to ensure they don't default on their loans. Now, the forint has room to turn around.

So if you can pick up a 10% return with the USD/HUF pair trading flat, then why not? And especially now that it seems that the worst is behind the forint, the price will float up to its true value. You'll see balance return to the forint's price. I think you'll see this currency finally make its way back as it puts the dollar to shame over 2009.

While the tide may not be turning for all exotics, the outlook for at least the forint and lira looks bright heading into 2009. Between the two, Turkey is the best pick in my opinion. The lira's higher interest rate will draw investment capital faster than the forint. When that happens, the lira will just get another boost.

Merry Christmas!
Sean