A term that many individual investors had not heard of until this week and now cannot get out of their heads is "carry trade".
The goal of this strategy is to borrow money at a low interest rate in one currency, convert the money into a different currency, and invest the borrowed money into a higher yielding bond.
This strategy has been implemented by currency traders for several years with the Japanese Yen (JPY).
For years, the interest rate in Japan was 0% and offered traders the ability to borrow in Yen and convert the money into another currency that offered higher rates such as the U.S. Dollars.
An example would be a trader borrowing Yen at 0.25% (the current interest rate set by the Bank of Japan) and reinvesting that money into a 10-year U.S. Treasury bond at 4.52%.
The numbers speak for themselves, and it is not difficult to figure out why this has been such a popular strategy with currency traders.
There have been a number of reports suggesting that traders will be looking to unwind their Yen carry trade positions. As the Yen rallies and the U.S. Dollar falls, the traders implementing the Yen carry trade could run into trouble with the real risk of losing money on the trade.
The unwinding of this trade would result in mass buying back of the Yen and selling of the other currencies. There are concerns that this action could result in a liquidity crunch worldwide.
To add fuel behind this unwinding threat, the U.S. Dollar, which has been in a downtrend since peaking in 2002, is expected to likely continue its slide lower. At the same time, the Japanese Yen just had one of its best weeks in a long time, rallying 3.7%.
From a technical viewpoint the Yen broke above an important resistance level that spurred on more buying to end the week. So if the unwinding of the Yen carry trade continues, how can the individual investor hedge their portfolio or better yet, profit from it?
Rydex Investments offers the CurrencyShares exchange-traded funds (ETFs) for investors that do not have access to a currency trading account. If you believe like I do that the Yen has more room to move on the upside, the CurrencyShares Japanese Yen Trust (NYSE: FXY) is your ticket.
Over the last week, FXY has gained 3.7% as the S&P 500 fell over 4%. Of the other currencies that Rydex offers ETFs in, the Swiss Franc (CHF) is currently yielding the second lowest interest rate. This led to a 1.2% gain in the CurrencyShares Swiss Franc Trust (NYSE: FXF) during the last week.
The debate between further unwinding of the Yen carry trade will go on for weeks, if not longer. If you would like to participate in the unwinding, the two best ETF options are FXY and FXF.
Even if the large unwinding does not take place, both ETFs should be able to perform well with the U.S. Dollar in a continued downtrend. Carry trade or not, these two ETFs are the best options for investors looking for a way into foreign currencies.