The End Of The Great Carry: Winners And Losers In A Post-QE World

Includes: FXE, UDN, UUP
by: Francesco Checcacci

There has been a lot of talk lately on the progressive exit of the Federal Reserve from quantitative easing, especially given that it seems to be the single event that has moved the markets most in the last few weeks.

We are witnessing a series of reactions in the risk assets, some of which seem to make more sense than others.

Let us first of all agree on a fact: if the Fed is even thinking of releasing some monetary stimulus measures it is because the fundamental data from the American economy have been looking much healthier lately. Unemployment is decreasing, which in turn has a positive effect on consumer and manufacturer sentiment. However, markets don't like uncertainty, and as an operation of the scale of quantitative easing was unprecedented, so are the effects of an increasingly probable exit.

Essentially I think QE started a massive carry trade since 2009, the dimensions of which were so big that the former engine of the world markets, the yen carry trade, pales in comparison. Thanks to QE, it became possible to borrow at very low rates in dollars and invest in higher return assets mostly quoted in dollars or in (officially or de facto) dollar-linked currencies.

The obvious beneficiaries of this trade were gold, bonds and stocks. Some stock markets, however, benefited more than others from the carry.

Emerging market stocks have arguably been the biggest winners of the great carry. Emerging countries with currencies officially or de facto linked to the dollar even more so. The most obvious examples that come to mind are China and Brazil. Although Brazil does not officially peg the real to the dollar, it is inevitable that its central bank tries to keep the exchange rate with the world reserve currency and the region's most important means of exchange under control.

Great Carry
(Click to enlarge)

An important fact is that the Fed is not likely to keep on rolling back its monetary stimulus without an eye to the American stock market. It is logical to suppose that if the Federal Reserve starts seeing the S&P fall significantly, it will intervene to calm the markets, either with ad hoc communications or with open market operations of some sort or both. Mr. Bernanke or his successor will be probably less prone to intervene if other assets were threatened.

European stocks, which have arguably benefited less than other markets from the great carry, also have a guardian angel in the ECB's Draghi, who has grown in his role to become probably the best communicator among central bankers. Recent meetings between Fed and ECB officials seemed to highlight an expectation that, when the Fed will finally start to roll back stimulus, other central banks are on the watch.

So the assets without a guardian angel, or those whose guardian angel lacks a flaming sword, are probably going to be the biggest losers in the game.

At this point let us highlight what should be the winners and losers:

Winners: the dollar, which has been the biggest loser of the Great Carry.

Losers: U.S. treasuries and dollar-denominated bonds; gold, which has raised a lot more than other currencies (just take a graph against oil); Chinese and Brazilian equities. There are signs that the Chinese and Brazilian economies are doing less well than was expected a few years ago. In part this might be due to the Chinese and Brazilian economies falling in the middle income trap, but this is a different topic. Compound this with less monetary stimulus from the U.S. and you most probably have a loser.

It is less obvious what will happen in developed stock markets. The U.S. seems on the way to economic recovery and as seen above, the Fed is not likely to ignore a falling stock market at home. In Europe, the increasing focus on growth and decreasing austerity talk, even from Berlin, will likely see fundamentals improve, especially after the German elections in September. As for Japan, the effects of Abe's "arrows" are still far from certain. Overall, however, a significant slowdown in emerging markets would surely hurt global economic growth if not balanced by increasingly better news from the developed world. The effects of the roll-back of QE will be interesting to watch.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Assets referred to: SPY, Eurostoxx, Hang Seng, Bovespa, Gold, Dollar