Sunday, November 8, 2009

And Now, the Dollar Carry Trade

The popularity of the yen carry trade since the mid-90s has waxed and waned and has defied several times premature proclamations of its demise. It has been linked to the development of market bubbles around the world, including the Asian financial crisis in 1997 and the global stock market rally in the late 90s.

For a good part of the last 15 years, the trade has been the darling of the hedge fund community, allowing investors and speculators to borrow in yen at the practically zero Japanese short-terms rates and then convert such borrowing into investments in other countries that were offering an appreciably higher rate of return. By doing so, they were, naturally, exposed to the risk associated with the country they were invested in as well as to the risk that the yen would appreciate sharply by the time they had to repay back the original loan. Still, the yen carry trade was offering lucrative rewards that were vastly overshadowing its implied risks, and this helps explain its remarkable longevity as the financing tool of choice for both speculation and more legitimate investment around the globe.

Predictably enough, there was a massive unwinding of such yen carry trades in response to the financial crisis set off by the Lehman affair last year, as emerging market economies were viewed as particularly vulnerable to the unusual intensity of the turmoil sweeping global finance. In recent months though, as emerging markets have largely defied those dire expectations and are increasingly coming out of the crisis, if anything, in better shape than most industrialized economies, the lessening of the earlier anxiety over their resilience has led to an impressive revival of the carry trade. The only difference is that the yen has now been joined by a very powerful partner that threatens to take the lead in that game: the U.S. dollar.

The dollar's joining of the global carry trade is the direct, and natural, result of the near-zero short-term rates in the U.S. since December 2008; in a way, it was almost an inevitable outcome. After some initial hesitation to assess the likely duration of the Fed's zero interest rate policy, global financial market participants have, in recent months, felt increasingly confident that the record low short-term rates in the U.S. are not likely to be reversed any time soon- an expectation that the Fed continues to nurture in its public pronouncements.

Having the currencies of the two major economies in the world (a somewhat qualified statement, as Japan is likely to be surpassed by China as the #2 economy by early 2010) becoming the vehicles for a global carry trade has some very potent implications. A record amount of foreign capital has been coming into emerging market economies in the last couple of quarters, fueling not only major stock market and commodity rallies but also classic speculative bubbles in real estate markets and other assets. (

In a somewhat ironic twist of events, it is precisely the very fact that the financial system in the major industrial countries suffered major damage in the midst of the crisis in the last eighteen months, that set the stage (via the zero short-term rates that it created in the U.S.) for the latest round of speculative bubbles already springing up around the world now. This dynamic, if it gathers more steam in the coming months (and, given that it involves a number of the Pacific Rim countries), may soon resemble the period leading up to the Asian financial crisis in 1997, which ended famously not so well.

Few emerging market countries have the luxury of taking measures to actually restrict such massive capital inflows, as they rely heavily on such flows to resume the faster growth rates they desperately need to continue lifting the living standards of large parts of their population. That is why it is an impressive testament to Brazil's solid position as an increasingly emerging economic global powerhouse that, last month, it imposed a 2% tax on capital inflows. This was a first, measured, act to stem the unfettered streaming of "hot-money" in to the country, that could plant the seeds of destabilization of one of the most successful economies in the world today.

The emergence of the dollar carry trade, which has clearly played its role in the weakening of the dollar since the first quarter of the year, and its already observable implications in a number of countries, creates another source from which the next pop in global financial markets may come. The risk for the latter will become more palpable when the time comes for the Fed to start reversing its near zero short-term rate policy.

Anthony Karydakis

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