It doesn't have to go that far at all, China and the rest of pacific rim slowing down faster than people expect will easily hurt that pair, there a variety of other scenarios that could occur as well. Directional risk is still there; the leverage you use for those triplep-digit APR's will hurt you just as bad in this department. Just because time is nominally on your side does not mean the risk you take is necessarily worth the reward -- you still need to time your entries into these pairs to come out ahead. Selling naked options is also generally profitable based on time decay alone but that's by no means the complete picture. As for differentials going away, my point is that traders will anticipate that reality way before the nominal rates begin closing those gaps; in that case the interest gained won't make up for the directional losses by the time differentials narrow significantly. Again, it all depends upon to what extent markets have already discounted that possibility, and how many players still remain caught looking the other way.
A trader said to me, what are you going to do when a pair like cable reverses its interest direction (like it recently has)...I simply said take a look at gbp/chf...I find that when one goes down one goes up...thus a large basket of currencies to carry is a diversified approach to this... The Forex market has not been kind to the banks...They are having trouble "pricing" in fundies...none of them made money this year, someone wrote. (I have not confirmed) Michael B.
"I find that when one goes down one goes up" This does not necessarily have to happen. Over a long period of time, it is pretty much guaranteed NOT to happen. There can be situations where bad things happen to a particular country. For example, I am thinking about the Mexican Peso Devaluations in 1982 and 1994-95. Your "diversified" basket is highly leveraged in the Mexican Peso. Diversification falls apart with high leverage. Having a short pair in another emerging market currency is not necessarily related.
I am not talking synthetics here.... I am talking about the hard-wired construction of Forex Pairs...
Maybe you could hedge using options. The fact is, you are exposed to certain pairs moving for/against you. Maybe you could buy an OTM option to protect you, at least a little bit, should an adverse 'event' happen.
I would not call 1.5:1 "highly leveraged", for the Mexican Peso position. More importantly, in my experience, such a basket is not meant to be put on and forgotten. It's not an insured bank CD on steroids (as appealing as that sounds). It's a good idea to monitor it, manage it and make adjustments as needed. Especially if there should be a currency shock somewhere.
Either way you slice it, the rationale of the carry trade since 2000 is no longer making as much sense due to structural changes in the host economies and saturation in the currency markets (this at least has certainly become the case with NZD) -- my feeling is this strategy will have to wait for another cycle of interest rate divergences vis-a-vis the majors or a large shake-out of current positions...unless something happens to the FX markets that creates the kind of structural changes that eliminate the wide differentials and the volatility we have seen in previous years. Some people are already starting to write about this scenario unfolding in the next decade...which would mean that just about everyone would have to change their strategies, from day trader to fund manager to international banker. Your basket as it stands is pretty solid. I can't find fault with it on paper, but if one of the majors (or one of the heavily weighted "minors") decides to burn a hole in your basket (for whatever reason) and you aren't fast enough to liquidate, your profits can evaporate in the course of a few days or hours. On another level, take a look at the macro picture for the dollar. Rumor has it in some circles that the carry trade that did so much to drive exchange rates last fall is "back in force" with the appreciation of the dollar. This time a small group of highly leveraged investors have borrowed in JPY and invested in an appreciating USD. What would happen if the dollar sold off sharply? Since the US is largely a supply-constrained economy and the rest of the world is largely demand-constrained, the net general effect of a dollar decline is not zero-sum but NEGATIVE as those investors suffer losses, sell their dollars, and send the currency further into the hole. This will not just be contractionary for the USD, but for most of the rest of the world's currencies...and, first and foremost, there is the hard economic conctraction to worry about. All theoretical, to be sure, but you get the point. Will you have that one currency that will save you from the rest? Will interest rate differentials really matter at this point? Depends on several factors -- time horizon, weighting, complexity of the management of your particular basket (i.e. the speed with which you can adjust to changes in exchange rates vs their swaps on your balance sheet, etc.)...and perhaps chance. Take a look at some of the research coming out of the banks and out of the think tanks concerning the long term efficacy of the dollar. They may not be right, but there are certainly ways to take advantage of rate differentials with less risk in any case. I've stopped making any sense, so I'll just end by saying that you're better off using another strategy until the macro picture clears a bit for the dollar and this won't happen any time soon. If you have enough kwan to make a carry trade matter substantially in terms of profits, then you have enough kwan to get caught in another currency crisis and there is no guarantee that at this level the liquidity of the FX markets will save you.
This simplifies to: Long AUDUSD Long NZDUSD Seriously, it does. With lower margin and saving paying the rate spread an extra five times. I don't like the basket unhedged. AUD and NZD, both commodity block currencies, are about 80% correlated over the past year. So you are exposed on both sides with little diversification. You could trade it hedged with an IB Universal account. Long Dollar Index futures trading at backwardation and short CRB Index furtures (or gold/copper...etc futures) trading at contango. .