Wednesday 3 March 2010
Unwinding of US$ carry trades, if it comes, may disrupt global markets
The recent rise in the US dollar - a carry trade currency - bears a haunting resemblance to the sharp appreciation in yen in early 2007, which left stock market carnage in its wake on fears of the unwinding of the yen ‘carry trade’.
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Unwinding of US$ carry trades, if it comes, may disrupt global markets
Emerging market outflows, recovery in US$ index cited
By OH BOON PING
01 March 2010
The parallels are there.
The recent rise in the US dollar - a carry trade currency - bears a haunting resemblance to the sharp appreciation in yen in early 2007, which left stock market carnage in its wake on fears of the unwinding of the yen ‘carry trade’.
Then, as now, Asian stocks were spooked by news from China, while Wall Street remains recession-wary. Except that this time around, any unwinding of the US dollar carry trade could prove to be far more devastating than the earlier episode, going by the size of the US-originated fund flows.
According to Gareth Berry, UBS currency strategist, the proportion of foreign stocks held by US asset managers between March and November last year ‘jumped from 23 per cent to almost 26 per cent as a percentage of their portfolios, amounting to outflows of about US$1.2 trillion’.
At the World Economic Forum in Davos in January, Zhu Min, deputy governor of the People’s Bank of China, put the size of the dollar carry trade at US$1.5 trillion - much bigger than the estimated US$1 trillion yen - meaning a reversal of that carry trade could severely disrupt financial markets worldwide.
The US dollar became a funding currency when the Fed slashed interest rate to 0.25 per cent and flooded the system with cheap US dollars.
As a result, some hedge funds and major global traders borrowed funds overnight in the US at very low rates and reinvested the proceeds into other currencies of hard assets like gold, crude oil futures and global equities.
Not surprisingly, between March and November last year, the US dollar index fell as much as 20 per cent against currencies such as the rupiah and the Aussie.
But signs of reversal are now showing, as US dollar trade-weighted exchange rate index recovered 3.4 per cent from its low on Dec 1, 2009.
Also, emerging market equity funds have seen their first outflow for three months as fears over monetary policy tightening in China, Brazil and India have increased.
For example, the MSCI Emerging Market Index has now dropped by nearly 7 per cent in local currency terms since its recent peak on Jan 11 - almost twice as much as the MSCI US index; and in the first week of February, foreign investors pulled another US$2.9 billion out of emerging markets equity funds, says EPFR Global.
Recently, private sector investors grew increasingly concerned not just about the situation in the southern periphery of Europe, notably Greece, but also Spain, Portugal and Italy, market watchers say.
Meanwhile, the Federal Reserve recently hiked its discount rate by 25 basis points, and investors see that as a sign of further tightening even though Federal Reserve chairman Ben Bernanke maintained that the Fed funds rate will be kept ‘exceptionally low’ for a long period.
‘With the European recovery lagging that in the US, and with the US likely to move towards a more restrictive fiscal and monetary policy stance over the next 12-18 months, we have seen investors cover their short US dollar positions, and in some cases start accumulating long positions in US dollar assets,’ said Peter Redward, head of emerging Asia research at Barclays Capital.
Figures from the Chicago Mercantile Exchange showed that speculators have cut their bets against the US dollar to go long, but pared their stakes on the euro and New Zealand dollar. As of Feb 23, net short position against the euro jumped 9,950 contracts, while the long position on kiwi dropped 1,043 contracts.
But Mr. Berry of UBS said that talk of a major reversal has been blown out of proportions as repatriation flows thus far ‘have been modest’.
‘The proportion of foreign equities has only declined to 25.6 per cent, leaving plenty of room for further inflows if risk aversion grows.’
For now, at least, it seems that the euro zone equities have borne the brunt of the selling, with clients only modestly cutting their positions in emerging market assets.
‘This could be a reflection of the belief that emerging market economies will prosper in the wake of the crisis while, for the larger developed economies, many years of lacklustre growth lies ahead,’ he explained.
In a Financial Times report, Marc Chandler at Brown Brothers Harriman says the longer-term market appears not to have unwound their carry trade positions significantly, with the US dollar’s recent rally more probably attributed to events outside the US.
‘While speculators in the futures market are short euro at record levels and have trimmed short US dollar positions, we suspect that the medium and longer-term investors are slower to reverse structural positions,’ he was quoted as saying.
‘The dollar’s recent strength appears to be more a function of bad news overseas than good news in the US.’
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