Implications of The Dollar Carry Trade

The currency carry trade is a strategy where the investor sells a currency with relatively low interest rate and buys a different currency yielding higher interest rates. Investors can also use the funds to buy other asset classes in different countries which would give superior returns.

The U.S. Government and the Federal Reserve has kept the interest rates at a record low level so that the U.S. economy recovers. According to the policy, keeping interest rates artificially low would ensure that small businesses, consumers and even large corporations would get easy funds and that would help in spurring the economy.

What the Federal Reserve has control over is to keep rates artificially low and throw enough money into the financial system. However, what the Federal Reserve has no control over is where this money goes (in terms of country or asset class).

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With negative real federal fund rates, who has the incentive to keep deposits in the U.S. Also, with easy money available, the big players have the incentive to borrow huge sums of money and invest in assets giving much higher returns outside the U.S.

Dollar Carry Trade and Asset Bubbles

The global equity markets have been racing away since their March 2009 lows and one of the primary reasons for this upside is the easy money available to speculate in different asset classes. There is no doubt that the global economy has shown signs of recovery (backed by Government stimulus). However, things are still not that rosy that markets can trade at such high valuations. A large part of this upside in markets have been driven by this easy money.

This can lead to the formation of several asset bubbles in different countries and different asset classes in the long run. The Federal Reserve has recently assured the global speculators that they can go on with their speculative activities by hinting that interest rates would remain low for an extended period. This is not surprising as far as the Fed is concerned. After the NASDAQ bubble, they had kept interest rates artificially low for an extended period and this helped create the housing bubble and subsequent crisis.

However, here the strength of the Fed's policy is largely blunted. The Federal Reserve has no control over where the bubbles are created. Ideally they would have wanted all the excess money to go into different asset classes in the U.S. itself as they are obsessed with the need for creating inflation or preventing deflation at any cost. But a large part of these excess funds are getting deployed into asset classes in emerging economies. I wonder how this will help a majority of Americans.

So, in the long run the Dollar Carry Trade has the potential to create several asset bubbles in different asset classes and lead to further difficulties and crisis in financial markets.

Dollar Carry Trade and Inflation

One of the honest and best ways to reduce deficits in the U.S. is to become more competitive in terms of exports. This would need greater capital investments in the country and also greater savings (instead of consumption). I am not sure how much the Government is doing on this front.

However, the U.S. has become a global leader in exporting inflation to countries around the world. This is one area where they can't be beat in my opinion.

Before the crisis, it was the $800 billion that was flowing out of the U.S. annually that created excess liquidity and inflation. Now also it is the huge deficits coupled with easy money flowing out of the U.S. that is creating excess liquidity globally and making the prospects of high inflation brighter in the long run for the world as a whole.

Speculation in commodities has a big part in creating inflation globally. I must add here that the long term fundamentals and supply/demand scenario of commodities (industrial and agricultural) means that prices will go up in the long run. However, the element of speculation (due to the free money available) will make prices go much higher than fundamentals justify. The long term downward trend of the Dollar will also ensure higher commodity prices. All these are a perfect recipe for inflation.

Dollar Carry Trade and the Dollar

The Federal Reserve was formed in 1913. Since then, the Dollar has lost over 90% of its value. The policies of the Fed are directed towards making this process more swift and efficient. Thus, it would not be surprising if the Dollar loses another 90% of its value in the next decade.

Real Value of the U.S Dollar

The more the amount of Dollars in the system, the less is the value of each Dollar. A greater amount of Dollars does not ensure higher purchasing power. For now, the amount of Dollars floating in the world economy is huge and growing rapidly. Thus, in terms of the value of each Dollar, the trend is likely to be downwards for a long time to come (confirmed by the Fed's announcement of keeping rates low for an extended period).

Nouriel Roubini's warning on Dollar Carry Trade

"Everyone is buying dollar at almost zero rate. There is eventually going to be an unraveling of this carry trade, When the snapback of the dollar occurs, it is not going to be 2% or 3%, it’s going to be more like 15-20%. Then, everybody would be left to close their shores on the dollar. You will have to sell these risky assets across the world and then you could have a huge asset bubble going into an asset bust. The crash will be as big as this bubble builds up to."

However, Mr. Roubini also said that:

“I don’t expect that however to occur in the short run because for the time being the Fed is on hold, they expect to stay on hold, they are not even finished to buy all the treasury and agency debt. So it is going to eventually occur but it is going to be six months from now or a year from now.”

The Economic Times, one of India's best financial newspapers also carried an article on the Dollar Carry Trade on the 6th of November 2009. The excerpts from the article on the perils of the Dollar Carry Trade are given below:

Perils of Dollar Carry Trade

Source: Economic Times (6th November 2009)

Firstly, 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 period culminating in the yen, which had been weakening for years, surging 20% in less than two months.

Secondly, when the yen rebounds against the dollar, it often snaps back very fast. So carry trades can go from profit to loss with almost no warning.

Thirdly, if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these destination-economies. So the perfectly correlated bubble across all global asset classes gets bigger and frothier by the day.

Comments

[Nom De Plum:]

I remember going to the arcade and getting $10 from my mom and cashing it in for quarters. The next hour was phenomenal. I played Kung Fu, Pole Position, etc. When my money ran out, I was depressed. I looked around and all I had were fleeting memories of recent fun times. My mom saw how dejected I was and gave me another $5 in quarters. She hoped that I would spend it on a book next door or save it so that it would create something tangible for me in the future. I plowed it right back into those machines because they were awesome and I would worry about learning or occupying myself later.

If you understood this story, then you will most likely weather the turbulent economic times we are living through.

If you think I'm some nutcase posting gibberish about my childhood, then don't be surprised to wake up in the future, maybe 2012, and have the true meaning of my story hit you like a ton of bricks.

Nov 11 01:45 PM