Is the U.S. Dollar the New Carry Trade Currency?

The Yen is the carry trade currency. You know, you borrow Yen, pay next-to-nothing interest, swap it for Australian dollars, and get high interest return on AUD. You own the license to print money, unless and until the Yen goes up in value. Then you may need/want to unwind -- sell AUD, buy JPY, which drives up JPY, which makes more people need/want to unwind. It's a positive feedback which, despite the word "positive", means it's destabilizing. Bad. Dangerous. Crash. Crisis. Bad bad bad.

Another possibility you may need/want to unwind the carry trade is the increase of risk aversion -- people want to hoard cash. Again, it's destabilizing positive feedback.

Our financial system is full of positive feedback. It's so full of inherent instability it's a wonder it didn't blown up completely ten years ago. Until we redesign it to eliminate such instabilities, it will blow up again. I believe it's possible to eliminate such instabilities; the key is to eliminate windfalls (spread it out), encourage long-term behavior and discourage short-term speculative behavior. But human society will not have enough political will to make such drastic corrections, not until we suffer greatly. The current crisis does not inflict enough pain.

Let's get back to carry trades.

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help it achieve this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. The Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. The USD is about the only other currency that strengthened across the board. Why is that? People think the US economy will bounce back fast? The USD is once again gold? Or even though the USD is not gold, everything else stinks even more? If you believe any of that, I have some wonderful organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut rates, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euros, Canadian dollars, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economies beyond hot, suck the lifeblood out of them, then leave them withering in rubble.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken. A system of traders and speculators but no investors is destined to be traded into oblivion.

Stock position: None.

Comments

[CLH:]

A good article. Yes the US dollar now makes sense for the carry trade. This may last for many years as the yen carry trade did.

2008 Oct 27 09:47 AM

[venividivici:]

Very good article BO!

2008 Oct 27 10:52 AM