ON RISKS OF A DOLLAR CARRY TRADE

SLIP-SLIDING AWAY

Barron's this weekend has a piece that may make one's head hurt at first reading, but is important enough to read twice.  Appropriately titled "Money for nothing and bucks for free", the piece makes the following point:

"The dollar could become the main funding source for the carry trade. To review, the carry trade consists of borrowing cheaply to invest in something with a higher return. ("Carry" in this instance refers to the cost of holding or "carrying" an inventory, be it a commodity or a security, which mainly consists of financing charges.)

The preferred way to fund the carry trade had been to borrow in yen, where the cost is near zero. Those yen could be converted into anything with a higher yield, such as U.S. mortgage-backed securities, to garner the spread.

The key risk -- aside from the loss of value of the asset being bought, as with any purchase on margin -- was that the cost of the liability would increase. That would happen with a rise in the yen in this case. And, not coincidentally, the yen rose in tandem with the dollar as carry traders had to unwind their positions during the crisis.

Now, with the Fed pinning the federal funds rate near zero and market rates -- such as the Libor, the London interbank offered rate, a money-market benchmark -- returning to their pre-Lehman collapse relationships versus the Fed's target, borrowing in dollars to fund carry trades looks tempting.

Remember, one of the big risks of a cross-border carry trade is if exchange rates bite you. But what's the risk of borrowing dollars at less than 1% if the U.S. currency's trend is down? Then you're effectively paid to borrow."

Why is this something to potentially worry about?  Well, it puts the Fed in a bit of a difficult position:

"America...still has a substantial current-account deficit that has to be financed with capital inflows. Outflows, as to finance dollar carry trades, would increase the need to attract capital inflows, which would put added downward pressure on the greenback.

Pomboy posits this could potentially lead to the return of such contrivances as the interest-equalization tax, a levy introduced in the 1960s to deter such outflows of capital.

Stanching the free flow of capital would be 21st century equivalent of the infamous Smoot-Hawley tariff, which importantly contributed to the contraction of global trade in the Great Depression..."

In choosing between the lesser of two evils, they may opt to allow the dollar to fall rather than impose draconian measures to curb dollar selling or deflating the economy to defend the exchange rate, the traditional medicine.

Then the response of other countries will be key. Do they permit an appreciation of their currencies, which would hurt their export competitiveness? Or do they follow the dollar's decline?

So far, equity markets have viewed the dollar's slide benignly. Stock investors haven't looked beyond the positive impact of exchange-rate moves on earnings of the Standard & Poor's 500.

But as the world sees a lower dollar as a one-way bet, it will be hard to stop."

Good point to keep in mind, especially for financial worry-warts.

* Image source.

Comments

[Alex Tolley]

"Stanching the free flow of capital would be 21st century equivalent of the infamous Smoot-Hawley tariff, which importantly contributed to the contraction of global trade in the Great Depression...""

But we had currency controls post Bretton Woods with teh fixed exchange rate regime and that wasn't exactly disastrous.

As a worry wart, I do think that the US' needs for capital inflow could be a severe problem, especially if the USD starts to look really weak. At the least this will drive up interest rates, at the worst it could mean severe credit contraction as inflows dry up.