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  Hairy Carry Trade
Reported by The Big Money on Tuesday, 17 November 2009 (on November 17, 2009)
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Hong Kong’s chief executive Donald Tsang blasted U.S. monetary policy at an Asian economic conference on Friday, saying that the Fed’s loose policies have created a “carry trade” in U.S. dollars that mirrors that of the Japanese yen earlier this decade, creating asset bubbles across emerging Asia-Pacific economies.
On Tuesday, Dallas Federal Reserve Bank president Richard Fisher threw cold water on what was otherwise greeted as good news: the Federal Open Market Committee’s decision to keep interest rates hovering around zero for the foreseeable future. Fisher acknowledged that the flood of U.S. liquidity creates conditions ripe for a dollar-driven carry trade that could have a destabilizing effect on asset prices. In addition, the recession’s most reliable Chicken Little, NYU’s Nouriel Roubini, warned Financial Times readers that the “mother of all carry trades” is brewing.
What is carry trade and why is everyone so worked up about it?
The term has its roots in commodities trading. Initially, “carry” referred to the cost of warehousing, or carrying, a commodity. If I invest in grain, the carry is what it costs me to keep it in a silo somewhere until I sell it. Carry can also be positive: If I hold onto that grain until February, the premium I can charge for it might outweigh what I’ve paid to store it. In the case of currency carry-trade, an investor borrows money in a currency that has a low interest rate, then reinvests it abroad in a currency that commands higher returns.
The huge amount of money the Fed has shoveled into the system, plus near-zero interest rates, makes dollars readily obtainable. If I borrow dollars at close to 0 percent, then invest them in a bank in another country where I can get a 5 percent interest rate, I pocket the difference. This is the most basic example of carry trade. If there’s enough easy money floating around, it’s going to start accumulating in real estate and other assets such as bonds, securities, or even overseas equities markets, potentially pushing prices up to bubble levels.
If I’m an investor, the risks can be as outsized as the profits. The first is if my starting currency goes up in value against whatever I’ve invested in. When I have to convert back, I could lose some or all of what I’ve earned—or even wind up owing money. The same holds true if the low interest rate I’m banking on suddenly shoots up before I can back out of my positions. If I’ve invested in more complex assets, I could also lose if the underlying assets lose value. Most carry-trade investors borrow on margin; that is, they only have to put up a fraction of the amount with which they’re wagering. As a result, even a small negative movement has an exponential effect.
It would be a guessing game to speculate how big the dollar carry-trade could get, but the Economist estimated in 2007 that a trillion dollars had been sunk into the yen’s carry trade at its peak. It’s hard to quantify the scope of the market because it’s so diverse. Investment banks, hedge funds, and institutional investors all play the game, and the concept of exchanging one currency for another in order to reap the interest is simple enough that it attracts its share of retail investors, too. When the yen carry-trade was booming, the financial media coined the term “Mrs. Watanabe” to describe the large number of Japanese housewives dabbling in the practice.
It’s unlikely that the dollar carry-trade will attract American retail investors to quite the same degree, because the domestic Japanese boom was fueled in large part by that country’s high savings rate, an area in which the United States is still playing catch-up. But we do love our easy-money hobbies, so it’s safe to assume some people will just trade foreign currency for condos in Florida as speculative vehicles.
Whether or not the growth accelerates to the point of creating the kind of bubble Tsang and others fear is up for debate. It is true that the dollar carry-trade has the potential to eclipse even that of the yen at its peak due to the size of our economy. The dollar is likely to be the carry currency of default as other central banks begin raising interest rates (Australia’s already has). It’s also apparent that right now the Treasury isn’t in any rush to make the dollar get up off the couch and earn its keep. A slack greenback gives a boost to American exports and makes our (prodigious) debt worth less. With unemployment continuing to rise, and consumers still spending with an eyedropper, the government wants to avoid anything that could create inflationary pressure.
As for the drawbacks, while economists are concerned about overheated asset prices, they’re far more worried about the impact of a desultory unwinding of the dollar carry-trade on economies worldwide. When the tumble comes, it can be quick and sharp. The value of the carry currency relative to others can spike due to increased demand when borrowers around the world all try at once to buy back that currency they bought on margin. Last year, the yen gained 34 percent against the euro in only a month. Some point to the collapse of the yen carry-trade as a major agent in the blowup of Lehman Bros. that ignited the subprime mortgage mess into a full-blown crisis.
The Federal Reserve’s Fisher expressed confidence that America can tighten its money supply in a measured fashion that will prevent what Roubini calls a “rush for the exit.” Even if the Fed were to give investors plenty of warning about rate increases or decreasing the money supply, though, outside forces could trigger an unwinding. An oil shock or major sociopolitical upheaval could dampen investors’ appetite for risk and make the dollar more attractive as a safe haven investment once again, which would send its value higher in a short time frame. As this article from the Milken Institute concludes, though, a blow of this magnitude might succeed in pushing the greenback off its pedestal as the world’s default currency.
Unfortunately, that probably won’t be the only casualty if Roubini’s darkest predictions come true. The U.S. economy is technically in recovery, but many metrics of fiscal health are still in the red, and a sudden drop-off in the dollar carry-trade could plunge us back into a recession potentially deeper than the one from which we’re still struggling to emerge.
Explainer thanks Jeffrey Frankel of Harvard University.
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