Sunday, October 26, 2008

USD Carry Trades?

Yen is the carry trade currency. You know, you borrow Yen, pay next-to-nothing interest, swap it for Australian dollar, get high interest return on AUD. You own the license to print money, unless and until Yen goes up in value. Then you may need/want to unwind -- sell AUD, buy JPY, which drives up JPY, which makes more people need/want to unwind. It's a positive feedback which, despite of the word "positive", means it's destabilizing. Bad. Dangerous. Crash. Crisis. Bad bad bad.

Another possibility you may need/want to unwind the carry trade is increase of risk aversion -- people want to hoard cash. Again, destabilizing positive feedback.

Our financial system is full of positive feedbacks. It's so full of inherent instability it's a wonder it hasn't blown up completely ten years ago. Until we redesign it to eliminate such instabilities, it will blow up again. I believe it's possible to eliminate such instabilities; the key is to eliminate windfalls (spread it out), encourage long-term behavior and discourage short-term speculative behavior. But human society will not have enough political will to make such drastic corrections, not until we suffer greatly. The current crisis does not inflict enough pain.

Let's get back to carry trades.

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help them achieving this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. USD is about the only other currency that strengthened across the board. Why is that? People think US economy will bounce back fast? USD is once again gold? Or even though USD is not gold but everything else stinks even more? If you believe any of that, I have some wonder organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut the rate, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euro, Canadian dollar, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economy beyond hot, suck the lifeblood out of them, then leave them withering in rubles.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken.A system of traders and speculators but no investors is destined to be traded into oblivion.


Anonymous said...

Yeah you pretty much nailed this. There are a number of us on Twitter talking about just such things, make sure you check out gregor's blog.




Bo Peng said...

SJ, I think you're right in that the surge in USD and JPY is short-lived. I really lost my interest in politics. The two parties are the same thing now, although they used to stand for something each.