The global economy is on a solid path to recovery. To get exposure, most investors immediately considered equities, which have been historically correlated with economic growth.
However, an even better option may be the forex carry trade.
The carry trade involves buying a high-yielding currency against a low-yield currency. Going long AUD/USD is an example. Historically, the carry trade has been highly correlated with global economic growth and thus the equities market.
The carry trade may also provide better returns.
The chart below shows that the Carry Trade Index handily outperformed the S&P 500 between 3/31/1999 to 2/7/2011.
Going forward, the carry trade may perform even better against the stock indices of developed countries because many of the high-yielding currencies benefit from rising commodity prices and emerging market growth.
The prime example is Australia, whose economy is driven by raw materials exports to China.
Currently, the most positively correlated currency pair to the S&P 500 is AUD/CHF, according to RBC Capital Markets.
The most negatively correlated pair is USD/CAD. Because it’s just as easy to go short as it is to go long in the forex market, investors can either long AUD/CHF or short USD/CAD.
Candidate currencies for the long leg of the carry trade are AUD, SEK, CAD, NZD, and NOK as they have high yields.
Incidentally, Australia, Canada, and Norway are also big commodity exporters.
Popular currencies for the short leg of the carry trade are CHF, JPY, and USD, which have low yields. Japan and Switzerland also happen to be net owners of foreign financial assets.
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