The New Carry Trade – U.S. Dollars, We Should be Interested and Concerned
Currency Carry Trade Definition: A carry trade where you borrow and pay interest in order to buy something else that has higher interest. For currencies, it might be that you borrow in Yen (where the interest rate might be low) and use the proceeds to purchase U.S. dollar long term debt. While the trade might produce a positive return, it is risky in two dimensions. First, U.S. rates could increase diminishing the value of the bond you purchased. Second, the exchange rate could take an unfavorable move effectively increasing your borrowing costs.
The infamous Japanese Carry trade raged on for over a decade – often called the “lost decade” for Japan. The interest rates in Japan never went above 0.5% making loans inexpensive. It seemed that no matter how much Yen was printed, inflation and growth remained elusive as much of the new money simply left the country through the carry trade. The carry trade died in Japan last fall as the result of the credit crisis.
The microeconomics dominated Keynesian and Austrians do not adequately consider the macro aspect of money created that leaves a country through the carry trade and/or foreign debt. Both of these create deflationary forces even though the money supply might point otherwise.
(Bloomberg) — Betting against the dollar is becoming the trade investors can’t afford to ignore.
The U.S. Dollar Index fell last week to the lowest level in a year as price swings in foreign exchange declined, encouraging investors to borrow greenbacks at record low interest rates and buy assets in countries offering yields as much as 8.1 percentage points higher than U.S. deposit rates. Borrowing costs in dollars as measured by London interbank offered rates fell below those of yen and Swiss francs for an extended period for the first time since 1994 during the past three weeks.
Those carry trades are the most profitable since before 2000, according to data compiled by Bloomberg. Borrowing dollars and then selling them is adding pressure on a currency that’s already weakened 14 percent since March as the budget deficit exceeded $1 trillion, the government sells a record amount of debt and the Federal Reserve floods the financial system with $1.75 trillion to pull the economy out of a recession.
Using the world’s reserve currency to fund carry trades became more profitable and less risky last month than with the yen for the first time since March 2008, Bloomberg data show. “The way everyone is funding their risky investments is by using dollars,” said Bilal Hafeez, the head of foreign-exchange strategy at Frankfurt-based Deutsche Bank, the world’s largest currency trader. “Interest rates between Japan and the U.S. are fairly comparable right now, which is incredibly unusual. Much of the past 20 years or so, the yen has been the funding currency of choice.”
An investor who borrowed $10 million dollars in March to fund the purchase of a basket of 10 currencies including the Brazilian real and South African rand would have paid 1.27 percent initially. The trade would have delivered a 29 percent return through last week as the offshore funding rate dropped to 0.53 percent, according to three-month deposit rates for the currencies compiled by Bloomberg.
The carry trade lures the biggest investors includiung hedge funds and with the big money comes bigger risks.
(Bloomberg) – Hedge Funds’ ATM Moves From Tokyo to Washington. Forget these nascent trade wars over tires, cars and chickens. China’s real problem is how quickly the dollars they hold in great quantity are getting all the respect of pesos these days. Sound like hyperbole? Not when you consider what may be the hottest investment of 2010: the dollar-carry trade. Move over Japan. Investors spent a decade borrowing in zero-interest-rate yen and putting the funds in higher-yielding assets overseas. It’s the U.S.’s turn to flood the world with cheap funding and the risks of this going wrong are huge.
The carry trade has never been a proud part of Japan’s post-bubble years. Officials in Tokyo rarely talk about the yen’s role in funding risky or highly leveraged bets on markets from Zimbabwe to New Zealand. Japan never set out to become a giant automated teller machine for speculators. It was a side effect of policies aimed at ending deflation.
The perils of the carry trade were seen in October 1998. Russia’s debt default and the implosion of Long-Term Capital Management LP devastated global markets. It was a decidedly panicky and messy period culminating in the yen, which had been weakening for years, surging 20 percent in less than two months.
Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely.
Think about the turbulence that would be unleashed by the dollar suddenly shooting 5 percent or 10 percent higher with untold numbers of traders around the globe on the losing side of that trade. It could make the “Lehman shock” look manageable.
The U.S. once was a beneficiary of carry trades. The gap between U.S. and Japanese bond yields offered a payoff. You could borrow for almost nothing and buy U.S. debt, receiving a twofold benefit: the 3-plus percentage-point yield difference and the dollar’s strengthening versus the yen. The latter dynamic boosts profits when they are converted back to yen.
Yen borrowers bought everything from Shanghai properties to Google Inc. shares, bars of gold, Zambian treasury bills and derivatives contracts. The odd thing, however, was the lack of credible data. When I asked Japanese officials in recent years for estimates of how big the yen-carry trade had become, I got blank stares.
That’s what makes such a trade worrisome and easy to dismiss as a threat to markets. No one knows how big it is — how many companies, hedge funds or mutual funds borrowed or how much. So when a currency turns suddenly, the magnitude of the unwinding is often a surprise. The dollar-carry trade says nothing good about confidence in the U.S. economy. It’s also a reminder that the side effects of this crisis may be setting us up for a bigger one.
The U.S. carry trade may be pushing the price of gold and other commodities higher, as explained in this article:
(Financial Post) – The carry trade always ends badly. The U. S. dollar is on a downward trajectory in a return of the carry trade that took the Japanese yen lower and commodity prices higher in the first half of the decade. A U. S. dollar costs next to nothing to borrow these days and is being used by hedge fund managers looking to make a quick buck in commodity-based currencies including the Australian, New Zealand, the Canadian dollars.
It was only a matter of time before the sharks smelled blood in the water and started feeding on the U. S. dollar, which has fallen 14% since the beginning of March relative to its major trading partners. Hedge funds are taking advantage of the very cheap cost of financing in U. S. dollars since the U. S. Federal Reserve cut interest rates to the bone last year to ease the pressure on the banking system.
The thing about this carry trade as we have learned is that it eventually ends badly. At some point the steady flow of money from funding currency to the high-returning asset reverses course and the whole edifice comes crashing to the ground.
So for now, the carry trade may be resurrected. With the global economy in the ascendancy, traders are betting that demand for commodities will continue to rise. If their premise is valid, commodity exporting countries will also experience currency appreciation making for a highly profitable trade in the short term.
The trade becomes self-reinforcing because commodities are priced in U. S. dollars and rise in value when the dollar falls, luring more speculators into the act, pushing prices even higher. Therefore, the price of gold, oil and other base metals as well as commodity currencies such as the loonie are likely to rise higher over the next year.
Here is an article discussing ETFs and the new U.S. carry trade:
ETF Winners of the “U.S. Dollar Carry Trade” The mainstream media continue to foster a notion that improving economic fundamentals are driving the cyclical bull. If that were the case, treasury bond yields wouldn’t be falling and gold wouldn’t be maintaining at the $1000 per ounce level.
If economic fundamentals were as sound as the media would have you believe, insiders at Toll Brothers wouldn’t be selling shares of their own company. For that matter, conventional mortgage rates wouldn’t be back at 5% and real estate organizations wouldn’t be begging for a continuation of the homebuyer credit.
I’ve pondered the simulateneous rise in gold, U.S. stocks, and U.S. treasury bond prices. I’ve wondered how 3 very different asset classes could move in the same direction for 3+ months… and do so as the U.S. dollar drops to new depths day after day. And I’ve finally come to a conclusion: This is the return of “a” carry trade.
An author named Don Christensen pointed out back in 1995 that every time the Fed cut rates to 3% or below, yield-hungry investors go to speculating, and it sets off a Bubble. His timing was great, because Bubble I (the tech bubble) was just launching as he wrote.
Christensen’s analysis went on bearing fruit, because the Fed kept making the same stupid mistake. When Sir Prints-a-Lot slashed the Fed Funds rate to 1% in 2003, it set off a flaming real estate rally (Bubble II) which ultimately blew out the GSEs. Nice work, Mr. G, SIR.
Now the new Bubble boy has gone and done it a third time. Bubble III is launching as we speak. Just look at stocks grinding higher. A few more months of this, and they’ll be back at Bubble valuations. Gold is near a record high. And the most depressed asset class of all, real estate, might even start Bubbling again.
Letting the dollar become a funding source for a global carry trade is a perverse, poisonous policy. Bubble III is gonna be the Mother of All Bubbles. And when it blows, there won’t be enough money in the known universe to save us. This time it won’t be just the GSEs going down, it’ll be GOVERNMENTS going down.
Welcome to Bubble III, my buoyant, bodacious buddies. As your local Realtor has always told you … “BUY NOW, BEFORE PRICES GO UP.”
WHO’S IN CHARGE OF THIS CRAZY CASINO, ANYWAY?
As usual, an insightful and highly entertaining post . . . One part of it raised my eyebrows . . . . that real estate may be on the verge of “bubbling” . . . could you elaborate, a bit? I just got off the phone with a Chicagoland carpenter’s union official, and he’s literally got only one active residential job throughout the Chicagoland area. Commercial building is also at a standstill. A year ago, on a trip downtown, one could see, at a glance, about 20 massive cranes on the Chicago skyline, putting up condos, hotels, office buildings, as fast as they could reach for the sky . . . . The other day, looking down on the city from the Indiana Skyway, I could see only one crane . . . . Skyscraper shells are completed on massive condominium and office buildings, but the interiors are just open space. The union officer told me that there are numerous commercial projects on hold because the banks aren’t lending. He was saying that “when the banks start lending again”, the floodgates are going to open on commercial building”. Naturally, I referred him to the Crash Course . . . . and CM, for a reality check . . . .
Don’t get me wrong . . . . it’s not that I doubt your assertion . . . . You’re way above my weight class with regard to economics . . . . But given that my husband is a contractor, I’d like to know what’s coming down the pike . . . .
For sure, real estate is going to take time to turn around. It’s like U-turning a battleship. What I’m looking at is the largest real estate ETF, called IShares Cohen and Steers Realty Majors (symbol: ICF). The ETF holds a portfolio of REITs, representing all kinds of commercial real estate.
Between Feb. 2007 and March 2009, ICF suffered a horrifying smash, falling from a high of around 115 down to 23. It was like the world was ending. Here’s a link to a 3-year chart of ICF:
But since March 2009, ICF has DOUBLED. Someone thinks real estate was oversold, and is turning around.
It isn’t going to happen instantaneously. But if you think about it, it’s when the sky is filled with cranes that real estate is headed for a fall. By contrast, when the empty shells of unfinished buildings loom over the city, the base is being built for the next move up.
The fiat currency system has an inflationary bias. When inflation begins rising again, people will pile into real estate as an inflation hedge. In the case of ICF, some of them already are doing so. I’m thinkin’ about joining them, in fact. I love fat yields (4.24%). I admit it — I crave income.
I truly respect your point of view, but I have to ask, aren’t you assigning a little too much power and control to the Fed? After all they are not bigger than the market. How can you assert that they are incompetent on one hand and say they are omnipotent in their effects on the market with the other hand?
Not omnipotent, Jeff. But the power to print money is the power to change the numeraire, the unit of measurement. If inches were dollars, I’d be twenty feet tall by now.
If you examine the two extraordinary Bubbles, the 1990s tech bubble and the 2002-2007 real estate Bubble, both were preceded by definite Fed actions. The Fed effectively slashed reserve requirements to zero in 1994, when they authorized banksters to execute ‘sweeps’ to convert deposit accounts into reserve-free savings accounts overnight. And in 2003, Greenspan slashed the Fed funds rate to 1%.
This time, Benny Bubbles has cut the Fed funds rate to zero. I know you don’t believe me … but as incredible as it seems, Bubble III is launching right now. When you can’t grow the economy the honest way — with productive investment — all you can do is blow Bubbles.
Bubble III is not only the biggest one of all … it’s the LAST one. We’re going for broke … and we’re gonna get there. WOO WOOOOOO … ALL ABOARD!
Thank you so much . . . . It’s refreshing to get an intelligible, patient, informed, and actionable response to my relatively naive questions. Thanks for being so generous with your time. You’re a gent . . . .
… but as incredible as it seems, Bubble III is launching right now.
The helium tanks are wide open. Just what the world needs, another round of pump ‘n dump.
aren’t you assigning a little too much power and control to the Fed? After all they are not bigger than the market.
The Fed controls the market, that is part of their charter. The idea was that they would control inflation and market volatility. First, they establish the interest rate and second, they intervene in markets on a regular basis. For example, the New York Fed runs the FOMC (Federal Open Market Committee) and the PPT (Plunge Protection Team) which are buying selling, shorting, whatever, through agents and other central banks – it’s all legal; well kinda.
A fascinating thing just occurred in the global interest rate market: For the first time since 1993, it became cheaper to borrow dollars than Japanese yen! The three-month dollar-based London Interbank Offered Rate, or LIBOR, slumped to 0.292 percent, compared with the yen-based LIBOR rate of 0.352 percent.
I know. You’re thinking: “Who the heck cares?” But this development is big — and so are the potential implications. It’s all because of something called the “carry trade,” which I’m going to get into right now …
The Carry Trade Explained …Let’s say you’re an international investor looking to boost your returns. One way to do that is to use leverage, or borrowed money. The cheaper you can borrow that money, and the greater the yield you can earn by investing it, the larger your returns. Every single basis point, or 1/100th of a percentage point, less you spend in borrowing costs falls right to your bottom line.
The carry trade is just a global version of this game. Investors seek out the lowest possible short-term funding costs by finding the economy whose central bank is being the most generous. Then they take that money, sell the country’s currency, and invest the funds in currency and asset markets that yield more.
That’s essentially what the world did for ages in Japan. Japan’s twin busts in stocks and real estate caused the country’s central bank to slash interest rates to near zero in the early 1990s. Japan also flooded its economy with trillions of yen in excess cash.
But the money wasn’t used by companies and consumers to spend and invest at home … they were burdened by excess capacity and gun-shy about borrowing after getting burned in stocks and real estate. Instead, the money was used by global investors to fund investments elsewhere.
The mechanics of the carry trade require that you sell the carry currency and buy foreign currencies against it. So one of the side effects is that it depresses the value of the borrowed currency. Another side effect is that the carry trade helps inflate global asset bubbles. Last time around, it did this by transporting the excess liquidity being created in Japan to foreign shores.
Now, thanks to the Federal Reserve’s incredibly easy policy stance, we may be in for “Carry Trade Round Two.” Only this time it’s not Japan’s currency that’s being sold relentlessly to fund risky bets …
Look at what the Fed is doing to our dollar!
Look at the chart to the left of the U.S. Dollar Index (DXY), which measures the performance of the greenback against six major world currencies (the euro, yen, British pound, Canadian dollar, Swedish krona, and Swiss franc). It looks like a ski slope, pointing down and to the right.
Unfortunately for dollar-based consumers (that’s us!), the falling dollar has side effects. It drives up the cost of imports, raising our cost of living. It also boosts the price of commodities like gold and oil. And it means the cost of travelling abroad goes up, too.
However, you can actually PROFIT from the trend by socking money away in contra-dollar plays. That includes natural resource stocks, gold, and foreign short-term bonds and stocks.
Thanks again for the response. Let me recap to see if I understood you correctly:
- The carry trade is effectively a short on the dollar (one borrows and then sells the dollar).
- A new bubble has been blown by Fed manipulation of interest rates and QE.
- This bubble will form the right shoulder of a giant head & shoulders pattern that has a downside target of near zero in all the US indexes. (from the previous thread Inverse Head & Shoulders on the S&P).
Based on these points, if correct, my inquires would be:
- The timing of this carry-trade (USD short) seems very risky IMO. Its analogous to shorting the indexes in mid March of this year. Only the dumb money would be shorting a market (USD) with this level of bearishness. The short squeeze risk here is tremendous, yes?
- Doesn’t it take a functioning fractional reserve banking system to blow a bubble? The Fed is rather impotent without the banking system (and consumer) on board, yes? I see no evidence that the credit markets are fueling another bubble, do you?
Thanks for taking the time to put this post together. You mention that the carry trade “never ends well,” but I’m not sure for whom it doesn’t end well for? The Japanese certainly weren’t ruined by the Yen carry trade, but Iceland was. Also, it seems like the ideal conditions exist for a dollar carry trade, but is there any hard evidence that such a carry trade is occurring?