Carry trades take the stairs up and the elevator down. This is common wisdom among FX traders and it was proven relevant again this week with the collapse of the Australian dollar. Unable to make a new high in April in its year-long bull run, we also saw an early neutral-to-bearish sign since the beginning of 2010 when the key 10- and 20-week moving averages started to go flat and cross.

In this way, the Aussie was a canary in the mines of investment risk because as the darling of risk appetite in 2009, it told you first in 2010 that trouble was brewing for global markets.

Below is a look at the chart this morning.

Click on image to enlarge!

Let’s break down a few elements worth noting on this chart. First, you can see the October acceleration to new highs in the tall green price bar that took the Aussie from below 86 cents to nearly 90. This was fueled by the central bank of Australia, the RBA, indicating that more interest rate increases were in store than the market was expecting. The RBA was bullish on the Australian economy and wanted to be ahead of the inflation curve with plans to take short rates from 3% to over 4% as quickly as possible. The second chart point worth noting is that the Aussie broke down through its 40-week moving average last week and this was a severe sign of weakness, especially as all these key long-term trend markers (the 10, 20, and 40-week) were converging just below 90 cents, signaling that the Aussie carry party was over. In media appearances on Monday and Tuesday of this week, while the Aussie tried to hang on above 87 cents, I said it was a done deal for it to test support at 86 cents and on a break of that to then fall to its 200-week moving average just above $0.8250.

The Bittersweet Love Affair with FX Carry
We got those moves very swiftly, as the carry trade “elevator” did a free fall through stop-loss orders, new hedge fund/bank/CTA momentum positions were added, and a general exit from all risk trades was the rule of the week—especially leveraged currency carry plays. Whether or not the extreme sell-off is justified is irrelevant. If you trade stocks, you know that markets swing to extremes and FX can often be more fickle than equity markets because the fundamentals are harder to quantify. Why is the currency carry trade so sweet on the way up and so bitter on the way down? Because what drives it up—a positive interest rate differential, economic growth attracting capital flows, and trend momentum—attracts so many leverage players and when the tide is reversing, they all cannot get out fast enough to preserve profits, or prevent accelerated losses.

Oversold and Due for a Bounce
I think the high-probability trade now in the Aussie is for a grind back up to former support at 86 cents and the 50-week moving average just above 87 cents. I’m not saying I would make a large leveraged bet in that direction. What I am saying is that we will likely see 85 cents before 77 cents (where the Aussie bears say it’s going) if the currency gets the one thing it needs right now—a bid in risk assets like equities. So if the S&P 500 Index stabilizes above 1,050, Aussie can rally. If not, then Aussie will continue to be sold as the last holders are liquidated. The second bounce opportunity will then come as S&P 1,000 and AUDUSD sub-$0.8000 are tested. There we are likely to see a reversal as selling momentum and fear reach their peaks and cooler heads who’ve been waiting for such a trade will step up and hit “Buy.”

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