With U.S. Dollar As Carry Currency, Fed Can't Tighten

Includes: CNY, GLD, UUP
by: Bo Peng

With the long standing and repeatedly reaffirmed Zero Interest Rate Policy (ZIRP) from the Fed since the 2008 crisis, it is safe to assume that USD has replaced the Japanese yen as the carry currency of choice. Likely major destinations of the carry trade include British pound, Canadian dollar, Australian dollar, and BRICS currencies (Chinese yuan may be diminishing lately).

The euro had been the primary destination in the early days of ZIRP era, before PIIGS had a Wikipedia entry, and it might still be a significant destination today given its size, although the risk in exchange rate has risen a great deal considering the ongoing euro crisis. I even suspect that one reason for JPY's stubborn strength is the unwinding of the massive carry trade in the decades prior and the shift to USD.

If this is indeed the case, then it is one more trap the Fed has dug itself into. With as much as a whiff of Fed deviating from ZIRP, this massive carry trade would unwind, pushing up USD and trade deficit, therefore hurting the economy and exposing "re-establishing the American manufacturing base" as a pipedream that it is. The unwind would be a multiplier in deleveraging and monetary tightening that's beyond Fed's control, greatly amplifying policy risk. In other words, Fed would be more nervous about tightening, thus further increasing the inflationary bias.

On the global scale, the world wide war of central bank printing has made sure that whoever daring to make the first move in tightening would be dragged out and shot. In fact, whoever daring to have an improving economic outlook, thus the expectation of tightening, would either have its currency pushed up by carry trade or the unwinding thereof, thus automatically dimming the economic outlook which is catch-22, or in the case of controlled exchange rate (CNY), forcing its central bank to print more, which is suicidal.

How does one express this view in trading? Patiently accumulate gold (GLD), commodities (e.g., USO), and stocks on rumors of Fed tightening. Aggressively short gold, commodities, stocks, and long USD (UUP) on news of Fed tightening, if that ever happens.

Disclosure: I am long UUP.