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The Duration Carry Trader


...when the carry trade changes, big changes are in store for all asset markets...

The USD/JPY is right at its highs for the day and week. Why? Once again the spread between JGBs and US Treasuries are at their widest levels of the week. (JGBs are Japan Government bonds, which are the equivalent of U.S. Treasuries.)

The USD/JPY has tracked very well with this spread for some time now. If this correlation changes, I think it would represent a very important moment. The reason this is important is because duration carry traders using JGB's versus Treasuries have two distinct risks.

The first risk is the spread risk. Let's look at an example of this. When a carry trader buys a 10 year Treasury and sells a 10 year JGB, the basic bet here is that the rates will converge (narrow) or stay the same over time, which allows the trader to earn the spread.

If they diverge (widen), the carry trader loses. When this spread widens it makes the trade more appealing (If one is looking at starting a position) because the spread is larger and the potential gains on the convergence of rates is larger.

But there is a second risk that this carry trade endures. And that is the currency risk. In the above example the ratio of USD/JPY is the currency risk.

The carry trader has exposure in the form of short JPY and long USD. Therefore the carry trader gains if the USD/JPY exchange rate increases and losses if it decreases. When the USD/JPY increases it makes the carry trade a less attractive trade to initiate because one is paying up for USD versus the JPY.

So when the interest rate (Between JGB's and UST) spread widens, making the carry trade more attractive to initiate, while at the same time the USD/JPY exchange rate increases, making the carry trade less attractive it presents an interesting scenario.

So as one risk makes the trade more attractive the other makes it less attractive and we have an interesting symmetry of opportunity for carry traders. But what if this symmetry breaks? It would signal a major shift in the actions of the carry traders and how/why it is being put on or taken off. And when the carry trade changes, big changes are in store for all asset markets, in my opinion.

Will duration carry traders get nervous that the Chinese are going to blow this symmetry up by selling USD, and by extension U.S. Treasuries, raising interest rates significantly?
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