Analysis from AdvisorAnalyst.com

Carry Trades Make and Break Markets

Global currency-carry trading deserves much more attention from investors, as it a substantial impact on markets, but it is a complex subject. In its simplest form, the most common carry trade strategy involves borrowing money from one country whose interest rates are low, to invest in the short term bonds of another country backed by higher interest rates.

Carry trading amounts to exploiting a free ride, but it is far from risk-free. Like all good things, free rides eventually end.

For over a decade, the yen was the primary funding currency used by carry-trading investors. Late last year that ended as interest rates across the developed world fell to near-zero levels.

"During the inflationary boom of 2002-2007, the yen carry trade fuelled many loans at the low cost of .25%. The yen-denominated loans allowed for strength in other assets in an apparent self-reinforcing cycle," wrote Jason Farkas, in October.

For the most recent nine months, however, large global institutions and hedge funds have taken the free ride, this time, courtesy of the U.S. dollar instead. This brief appointment for the U.S. dollar as a funding currency has resulted in adding fuel to the rapid global recovery in assets, as it followed upon the end of the yen carry-trade decade.

Fred Dickson, chief market strategist at Davidson Companies, wrote recently, "Investors in all kinds of financial instruments have been impacted by the carry-trade strategy as the size of these trades have contributed to the big move in commodity and stock prices over the last year."

"The dollar's role as a funding currency is fleeting at best," said Samarjit Shankar, a foreign-exchange group managing director in Boston at BNY Mellon, the world's largest custodial bank at more than $20 trillion in assets. "When central banks start raising rates, the yen will be left behind as the primary funding currency."

The dollar's weakness during the last year has translated doubly into stronger prices for equities, commodities, gold, and other risk assets. Shorting the dollar weakened the dollar relative to risk assets, and investing the proceeds in risk assets boosted their value. In November, concerns began to mount that good news from the U.S. economy would jeopardize the U.S. carry trade as it may lead the U.S. Federal Reserve to change its bias to hawkish.

"The carry trade is 'the biggest time bomb,'" Dong Tao, a Hong Kong-based economist at Credit Suisse, said today at a press briefing in the city. He was referring to investors buying higher-yielding assets with money borrowed in nations with low interest rates.

Such transactions may involve between $1.4 trillion (U.S.) and $2 trillion and "unwinding" the investments could cause volatility in currencies, commodities and emerging market stocks, Tao said. Unwinding these trades means selling the assets to buy back dollar positions. The outcome would be terrible for assets, and bullish for the dollar. If it happens too quickly, the dollar could get caught in a short squeeze and rise very rapidly, and risk assets could sell off dramatically.

Elliott Wave's Jason Farkas says that "when the U.S. dollar begins to rally, it will likely signal the end of liquid markets."

According to Bloomberg, record deflation has prompted the Bank of Japan to start a $113 billion (U.S.) lending program last week. By easing demand for private-sector loans, the move helped shrink the gap between U.S. and Japanese London interbank offered rates by two-thirds over the past three months to 0.024 percentage point.

The BoJ's continued intervention has led to a view that the dollar carry trade will be replaced by the Yen.

In conclusion, the warnings are timely. We tend to be overly focused on domestic concerns and seldom take into account the sensitivity of the markets to global currency transactions and the exploitation of easy money. Having said that, its hard to overlook the idea that bad news for Japan is good news for the U.S. dollar, and assets backed by carry trades.

Tao's outlook holds water, however he does not take into account Japan's woes, and that's where BNY Mellon's Shankar's view comes in. Japan's policy making, which amounts to quantitative easing, couldn't have come at a better time for the carry trade and risk assets. The carry-trade-exchange period ahead promises to be tricky and volatile, but I think not Tao's "time-bomb."