Investors may come to grief when US dollar carry trade unwinds
By Goh Eng Yeow 26 November 2009
Tiny movements in the United States dollar may not make much of a difference to the man in the street, but each gyration is minutely scrutinised by hawk-eyed traders across the world.
This is not surprising. Since March, there has been an almost perfect correlation between widely watched stock market indexes such as the Straits Times Index and the weakening greenback.
For traders, betting that regional equity markets will leap in jubilation each time the greenback turns wobbly has become something of a no-brainer.
The uncanny link between the two is largely the result of what is known as the US dollar carry trade - an extremely profitable strategy that has become highly popular with fund managers striving to make a comeback after getting burnt in last year’s global market meltdown.
Like all good investment ideas, it works quite simply: Investors borrow huge quantities of US dollars for short periods of time at almost zero cost, as the US central bank has pared interest rates to almost zero in March.
The money is then used to buy assets with higher returns, including other currencies paying more attractive interest rates, stocks in Asian firms that have emerged almost unscathed from the global recession, and corporate bonds.
This strategy creates two sources of profit - returns on the assets bought, plus any foreign exchange gains made if the currency in which the asset is bought rises against the ailing greenback.
Since the performance of many hedge fund managers is measured in US dollars, there is a strong incentive for them to make larger gambles each time the greenback weakens against regional currencies.
While traders agree that the US dollar carry trade is thriving, what is unclear is how big the trade actually is, or how worried investors should be about it.
In the decade prior to the global financial crisis two years ago, the carry trade’s role had been largely taken by the yen.
This strategy began to unravel last year as the wobbly greenback weakened against the yen, triggering a huge unwinding of positions, which aggravated the plunge in commodities and emerging market equities when investment bank Lehman Brothers crashed.
However, the US Federal Reserve’s priming of the global financial system with US$1.8 trillion (S$2.5 trillion) of freshly printed money means that the carry trade is back with a vengeance, and the greenback has taken over from the yen as the main carry trade currency.
There are unmistakable telltale signs pointing to the US dollar carry trade’s rapid development. One of the biggest giveaways is the weakening of the greenback against other carry trade currencies such as the yen, as punters switch out of funding one currency into another. With US dollar interest rates currently running at almost zero and close to Japanese rates, investors have been replacing their yen loans with greenback borrowings.
In doing so, they have been buying Japanese yen to repay their loans, causing the Japanese currency to surge 14 per cent against the US dollar since April.
A galloping US dollar carry trade has far wider implications for the global financial system, as the greenback is also the world’s currency for commerce.
Prominent US economist Nouriel Roubini has warned that the availability of cheap US dollar funds is fuelling a gigantic asset bubble across the globe. ‘Every investor who plays this risky game looks like a genius - even if they are just riding a huge bubble financed by a large negative cost of borrowing,’ he wrote recently.
A weak US dollar makes the US federal budget deficit easier to fund and may be good for the US stock market, since it makes the foreign currency profits of US firms abroad look bigger.
But the resulting flood of liquidity has spawned a stock market boom from Mumbai to Shanghai, propelling share prices back to their pre-Lehman crisis levels.
‘But one day this bubble will burst... The US dollar cannot fall to zero and at some point it will stabilise,’ Mr. Roubini said. And he has painted several scenarios that might cause the greenback to regain its former strength. The US dollar could start to recover if US economic growth is on the upside over the next few quarters, and this might force the Fed to start hiking interest rates sooner than expected.
Investors still view the US dollar as the safest currency to hold if there is a flight from risk prompted by fear of a global double-dip recession or a military confrontation, and this might cause grief to those with huge US dollar loans as the greenback strengthens. There is already a precedent. The regional stock market boom between 1992 and 1996, which was spawned by cheap yen loans, ended in grief in 1997 when the collapse of the Thai baht brought the whole region to its knees.
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Ailing greenback may fuel giant asset bubble
Investors may come to grief when US dollar carry trade unwinds
By Goh Eng Yeow
26 November 2009
Tiny movements in the United States dollar may not make much of a difference to the man in the street, but each gyration is minutely scrutinised by hawk-eyed traders across the world.
This is not surprising. Since March, there has been an almost perfect correlation between widely watched stock market indexes such as the Straits Times Index and the weakening greenback.
For traders, betting that regional equity markets will leap in jubilation each time the greenback turns wobbly has become something of a no-brainer.
The uncanny link between the two is largely the result of what is known as the US dollar carry trade - an extremely profitable strategy that has become highly popular with fund managers striving to make a comeback after getting burnt in last year’s global market meltdown.
Like all good investment ideas, it works quite simply: Investors borrow huge quantities of US dollars for short periods of time at almost zero cost, as the US central bank has pared interest rates to almost zero in March.
The money is then used to buy assets with higher returns, including other currencies paying more attractive interest rates, stocks in Asian firms that have emerged almost unscathed from the global recession, and corporate bonds.
This strategy creates two sources of profit - returns on the assets bought, plus any foreign exchange gains made if the currency in which the asset is bought rises against the ailing greenback.
Since the performance of many hedge fund managers is measured in US dollars, there is a strong incentive for them to make larger gambles each time the greenback weakens against regional currencies.
While traders agree that the US dollar carry trade is thriving, what is unclear is how big the trade actually is, or how worried investors should be about it.
In the decade prior to the global financial crisis two years ago, the carry trade’s role had been largely taken by the yen.
This strategy began to unravel last year as the wobbly greenback weakened against the yen, triggering a huge unwinding of positions, which aggravated the plunge in commodities and emerging market equities when investment bank Lehman Brothers crashed.
However, the US Federal Reserve’s priming of the global financial system with US$1.8 trillion (S$2.5 trillion) of freshly printed money means that the carry trade is back with a vengeance, and the greenback has taken over from the yen as the main carry trade currency.
There are unmistakable telltale signs pointing to the US dollar carry trade’s rapid development. One of the biggest giveaways is the weakening of the greenback against other carry trade currencies such as the yen, as punters switch out of funding one currency into another. With US dollar interest rates currently running at almost zero and close to Japanese rates, investors have been replacing their yen loans with greenback borrowings.
In doing so, they have been buying Japanese yen to repay their loans, causing the Japanese currency to surge 14 per cent against the US dollar since April.
A galloping US dollar carry trade has far wider implications for the global financial system, as the greenback is also the world’s currency for commerce.
Prominent US economist Nouriel Roubini has warned that the availability of cheap US dollar funds is fuelling a gigantic asset bubble across the globe. ‘Every investor who plays this risky game looks like a genius - even if they are just riding a huge bubble financed by a large negative cost of borrowing,’ he wrote recently.
A weak US dollar makes the US federal budget deficit easier to fund and may be good for the US stock market, since it makes the foreign currency profits of US firms abroad look bigger.
But the resulting flood of liquidity has spawned a stock market boom from Mumbai to Shanghai, propelling share prices back to their pre-Lehman crisis levels.
‘But one day this bubble will burst... The US dollar cannot fall to zero and at some point it will stabilise,’ Mr. Roubini said. And he has painted several scenarios that might cause the greenback to regain its former strength. The US dollar could start to recover if US economic growth is on the upside over the next few quarters, and this might force the Fed to start hiking interest rates sooner than expected.
Investors still view the US dollar as the safest currency to hold if there is a flight from risk prompted by fear of a global double-dip recession or a military confrontation, and this might cause grief to those with huge US dollar loans as the greenback strengthens. There is already a precedent. The regional stock market boom between 1992 and 1996, which was spawned by cheap yen loans, ended in grief in 1997 when the collapse of the Thai baht brought the whole region to its knees.
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