donderdag 6 november 2014

Correlation: Carry trade Vs. Stocks

A carry trade can occur when a currency A is borrowed to buy another currency B. That other currency can be used to buy assets like equities (or short gold).

There are two prerequisites to have a profitable carry trade.
One, the currency A needs to depreciate against the other currency B.
Two, the yield on the other currency B must be higher than the carry traded currency A.

A famous carry trade is the yen carry trade where yen are borrowed to buy U.S. dollars. We have seen this during the housing bubble from 2003 to 2007 where yield spreads were very high (see chart below) and we are seeing this happening again today in 2013-2015 where we have again a stock bubble.

Whenever this yield spread narrows again, the probability of a crash increases. I see this carry trade yield spread as a leading indicator for the stock market.

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