The euro is quickly becoming the funding side of carry trades with its recent interest rate cut and future prospects. The Australian dollar has always been a likely target currency for the carry trade, with its stability and relatively high yield, which makes the EUR/AUD pair the perfect candidate for a carry trade. Technical patterns also point to this pair moving to the bearish side.
The carry trade, buying high yielding currencies using low cost currencies as funding, has been dominated by Japan in the past few decades as low inflation (even deflation) kept interest rates at extremely low levels for some time. With the recent announcement from the European Central Bank (ECB) that they will charge for overnight deposits and lend out at a mere 0.10%, the Euro has become an excellent funding source for the carry trade.
With Japan taking its mission of encouraging inflation very seriously, long term carry trades may be at risk of becoming more expensive and possibly suffer from currency risk if the yen strengthens. The Euro on the other hand (while trying to combat deflation) is likely to see more stimulus and further devaluation of the currency. This means traders will not only benefit from the yield of the carry trade, but paying back the loan will be cheaper too.
That brings us the Australia. The traditional high yield of Australia has made it attractive to many investors seeking returns, and the stability of the political regime has given investors confidence. The RBA has said that rates will be on hold for some time, as commodity prices weaken and the outlook for Australia looks a touch uncertain, but the market still believes the next interest rate movement will be up and the new government is aware of the need to rebalance the economy away from the mining sector. The current interest rate in Australia is 2.50%, making the differential on the EUR/AUD trade a decent 2.40% yield.
The EUR/AUD already looks to have benefited from the expected fall in interest rates as a peak was hit back in January at 1.58298. This peak was the ‘head’ in a very good looking head and shoulders pattern, indicating a bearish reversal that has come to fruition. The red line on the below chart represents the ‘neck line’ which you can see the price has bounced off recently before moving lower.
Another feature of the EUR/AUD chart is the descending wedge that is forming as the price moves lower. The price is being squeezed, which usually leads to a breakout, in the case of a descending wedge it will be on the bearish side. Anyone looking to time their entry into the EUR/AUD carry trade could wait for the breakdown of the wedge by setting an entry below the bottom line of the wedge. The Stochastic indicator is showing lower highs, indicating the momentum is certainly with the bears at the moment. Support levels at 1.4313 and 1.4127 are likely to be tested and may be good places for trades to take some profits off the table, otherwise hold on and enjoy the return on the swap.
The Euro is likely to become the base for may carry trades to come with fundamental differences in monetary policy making it an attractive short. The AUD is a likely target and technical analysis points to return from price movement along with the interest rate differential.