Tuesday, March 29, 2011

Dollar Carry Trade.

What has happened is that the United States has become the world's financing machine, but in a dangerous way. What used to be known as the "yen carry trade" has now become the "dollar carry trade."

It works like this. Because rates are so low here in the U.S. market, investors and leveraged speculators borrow cheaply from U.S. banks and lenders. They take the borrowed dollars into the world currency markets, where they sell them and buy other currencies (these other currencies, of course, are from markets with higher interest rates).

Collecting the higher return from the interest-rate differential, or when investors bid up other asset prices with the cheap money they've borrowed, is known as a "carry trade," because the transaction is financed, or "carried," by borrowing cheaply.

And it's now technically the "dollar carry trade," since U.S. dollars are the currency being used to finance these often leveraged and sometimes speculative trades.

For years, because Japan's economy suffered from a stock market and real estate implosion, to keep the economy liquid the Bank of Japan (BOJ) kept interest rates lower than anywhere else in the world. That's how the Japanese yen carry trade came about in the first place.

Now the dollar-carry trade has replaced it.

One big problem with these trades is that they are leveraged trades. So if the U.S. dollar starts to appreciate - no matter what the reason - then the dollar carry trade can quickly become a loser if the amount of interest earned is eaten up by having to buy back "shorted" dollars that are rising in relative terms. The act of buying dollars back raises the price for other traders still in their trades. And if those traders have also "leveraged up" on positions in other asset classes, there could be a mad rush for the exit doors and a wholesale dumping of assets - a classic, and potentially ruinous, "short squeeze " - as the dollar rises.

What could cause the dollar to rise?

Though it might be surprising to some, there are plenty of credible candidates. There are also a gaggle of questions to be answered. For instance:

How about, for starters, what happens when "quantitative easing" is over? What happens when the central bank has to signal to the world that it is willing and able to do something about inflationary expectations?

What will happen if our rates start to rise because fewer and fewer investors will want to buy our government's debts, and won't accept the piddling returns they get on their U.S. Treasury holdings?

What will happen if strong growth returns to our shores? Will there be enough money to lend to meet demand? We'll find out then if our banks are really as flush with cash as they claim to be.

A rising dollar would make commodities cheaper, which is a good thing. Unless you are one of the millions of speculators who bid them up, or any of the emerging markets countries like China that's been stockpiling them.
A rising dollar would make oil cheaper, which is a good thing. Unless you are one of the many countries that sells it and needs increasing oil revenue to meet budget demands.
The whole problem with the Fed's policy of engineering artificially low interest rates is that it distorts the free markets. Naturally rising rates would have snuffed out the subprime spree, as well as the excessive speculation in leveraged assets that could be financed so cheaply back then (a capability that still exists today).

Courtesy: http://moneymorning.com/2011/03/29/the-death-dollar-carry-trade/

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