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.
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