The AUD/USD currency pair has been characterized by a high interest rate differential; indeed Australian Dollar is one of the highest-yielding currencies which creates very interesting patterns related to the famous phenomenon of carry-trade — and its violent unwinding.

In this report we focus on the period from 00:00 2002-08-20 to 00:00 2008-02-01 (New York time).

### Trend predictability: try catching a falling knife!

In this figure we look for obvious arbitrage opportunities on the time scale of up to two days (corresponding to day trading or swing trading) — and there is one thing that’s quite spectacular. The hatched red band shows the range of statistical noise (namely its expectation plus minus its RMS deviation). Statistical noise was obtained by simulating 20 independent time series of the length corresponding to that of the AUD/USD series, each one constructed to reproduce the measured distribution of returns for AUD/USD for the time period under study (including the fat tails!), but completely devoid of correlations. From these, the expectation and RMS or the autocorrelation amplitude in each time lag bin were calculated.

Now to the main non-random feature here: the huge negative correlation signal at one hour lag overshoots the level of noise by a huge factor. The autocorrelation being an average of a product of hourly returns taken with a lag, this negativity means that we are way too frequently taking a product of opposite sign returns — or that the product of the opposite sign returns far outweighs that of the same sign returns. In other words, the AUD/USD price quote is *a lot* more jittery than what “financial theorists” who preach market efficiency (expecting this plot to be similar to what is represented by the red band) believe.

Because trend reversals on the time scale of one hour or less happen either too often or are too lucrative, AUD/USD may well be the market where winning strategy requires being a clever contrarian. In the next figure, we increase the time lag bin to four hours to try and see if we can locate a trigger signal — something that could alert you to take a contrarian position with more confidence.

The striking feature of this plot is the 24 hour cycle of bullish and bearish action, clearly seen as the maxima of the correlation are located at multiples of the 24 hour lag: 24, 48, 72, 96, 120 hours and so on. Therefore, smart trend following means something more than following a trend that existed in near past. It means following a trend that existed this time of the day yesterday, the day before yesterday, and so on — that gives you better than average chance of winning! Conversely, buying because the currency went up 12 hours ago (or selling because it went down 12 hours ago), *all the rest being equal*, is the least recommended strategy. (See why the sub-sample correlation feature is not in itself a prediction strategy.)

Note that whether this oscillation pattern is equally strong in all time zones is a question that requires a separate study.

But there is something more: note the dramatic difference between bullish and bearish histograms. The bearsih (blue), besides exhibiting cyclic oscillations with a 24-hour period, shows a lot of correlation around 0 peak. This is most likely related to the phenomenon of carry-trade unwinding. The carry trades in the period under study are funded by borrowing in low-interest currencies like JPY and CHF and converting into high-yielding ones like AUD and NZD. These positions build up over time but once opened, the owners have a common interest in being able to close with a profit. Because of that, these positions tend to be closed over short time periods driving JPY and CHF up and AUD and NZD down (through excessive demand and supply, respectively) — and as a side effect, the AUD/USD rate goes down as well when this happens. What the plot shows is that once the AUD retreat began, it’s a safe bet that that the dynamics will continue for up to two days. This is *not true* with AUD rallies!

The 24-hour period effect seen in the previous figures has a certain life time. This figure shows this life time. The effect definitely persists for as long as 1000 hours or well over a month of trading time.

### Summary

We conclude that attempts to “beat the market” with AUD/USD on the time scale of day-trading should work: this is not a “fair game” by any stretch of imagination! Strategies should focus on trend reversals and detection of carry-trade unwinding. Long term prospects of this currency pair are the subject of fundamental analysis and are outside the scope of this article. Cross-correlations with other markets are to be discussed in the up-coming articles. Cross-correlations with currency pairs involving NZD, CHF and JPY will likely be among the most interesting ones.