Perils of dollar carry trade

06-11-2009

Stock Market

The Economic Times

Over the past year, the dollar has increasingly been at the epicentre of a so-called “carry trade.” The Fed has been injecting liquidity into

the monetary system to stimulate lending. Banks have the options of putting this money at the Fed at 0.25% (on excess reserves at 0.15%i) or invest t in assets providing better returns. With interest rates effectively at zero in the US, stock and commodity traders are borrowing risk-free dollar at negative 20% interest rates (the fall in the US dollar leads to massive capital gains on short dollar positions) and investing in higher-yielding currencies and assets, such as stocks, commodities, oil, gold and emerging markets.

The announcement at the end of the two-day FOMC (Federal Open Market Committee) meeting on November 4 that policy interest rates will stay “exceptionally low” for “an extended period flashes a green light for the dollar-funded carry trade that has suddenly come in fashion and is conceivably behind the all-asset rally that has gained momentum since March 2009.

In the process, the ‘dollar carry trade’ will accentuate what is already a wide gap between valuations and the outlook for economic fundamentals in 2010. People’s sense of the value at risk (VAR) of their aggregate portfolios ought to be increasing due to a rising correlation of the risks between different asset classes, all of which are driven by common monetary policy of central banks and the dollar carry trade.

Last year, anyone borrowing in yen to buy Australian dollars, a popular trade with Japanese housewives (‘Mrs Watanabe’), would have lost 45% of their money in three months. That is why some equate carry trading with holding equities — both are great investments until they blow up. Still, carry strategies have outperformed cash since 1999 by an annualised 8%, rising by a fifth this year alone. Currently, carry trades have got ahead of themselves, returning to 2006 levels whereas equities trail three years behind.

What is more, if carry trades are the rage again due to animal spirits, why is ultra-safe gold at an all-time high? The yen and Swiss franc, traditional borrowing currencies, are also rallying. Perhaps investors reckon they are onto a “sure thing”. And we all know — there is no such “sure thing”.

Japanese investors are another big engine behind this new carry trade dynamic. When Japanese institutions invest in US dollar denominated assets, they become exposed to forex risk. As a natural hedge, they can make their liabilities also dollar denominated. In other words, they can borrow in ever-diminishing-in-value dollars to finance their investments. The graph below shows a clear correlation between the lower rates in US and the recent yen appreciation. The Japanese yen closely tracks US LIBOR. Why carry trade is dangerous ?

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.