Carry Trade - Path to another financial turmoil?

For financial sector enthusiasts, the word ‘carry trade’ is not new. It has been in existence for over two decades and has been popularly known as “yen carry trade”. This investment strategy has come to the limelight in the last fortnight, as noted economist, Mr. Nouriel Roubini know as Dr Doom, spoke about the US dollar milking the mother of all carry trades. Nouriel Roubini’s claim to fame has been his prediction of the current economic recession and hence his view invites scores of thinkers and market analysts to analyse the subject.

Carry Trade- How does this investment strategy work?
Simply put, investors which include financial institutions and hedge funds, borrow money in a currency that is cheaply available ( in this case the US dollar) i.e. at phenomenally low rates of interest and invest in off-shore asset classes that provide higher rates of interest. The asset classes could include stock, bonds and commodities among others.

The risks involved include exchange rate risk (movement of the funding currency) and risk of the asset class in which the investment has been made. Likewise, the return from this strategy includes gains/losses from movement in currency and gain/losses from the investment in the asset class.

The premise on which carry trade functions is

• The funding currency (in this case the US dollar) will weaken or at best remain stable and

• The Central Bank of the funding country intends keep the borrowing costs low

Currently the US dollar is available at near zero rates and the US Fed has indicated that rates will remain low for an extended period. This has encouraged traders to resort to the “US dollar carry trade” investment strategy (US dollar is used as the funding currency) for quick bucks. After all, who doesn’t want to make hay when the sun shines?

What has been past experience on Yen carry trade?

The past two decades had seen the yen carry trade grow to several billions of dollars, the quantum of which is debatable, on account of easy availability of funds at low interest rates in Japan- the loose monetary policy stance adopted to awaken the sleeping giant. The most popular trade then was the dollar yen trade. The gain was twosome- return on the asset class and profit on exchange rate on account of a deprecating Yen.

Tables were bound to turn at some point in time. In 2007, Yen took an about turn and started appreciating. The appreciation was significant enough forcing traders to unwind the Yen carry trades. This had an impact on markets as positions were getting liquidated. The unwinding of carry trade coincided with the downward spiral that the Dow witnessed from around 14,000 to 7,000 levels.

Will dollar carry trade lead to carnage in the financial markets?

For traders, carry trade with US Dollar as the funding currency is an excellent money making opportunity as the Fed has indicated that rates will not head upwards anytime soon. Also the latest reading of the unemployment numbers which has now crossed the 10 per cent mark in the US will make it difficult for the Fed to think of interest rate hardening in the immediate future. Besides, the depreciating US dollar adds to the gains of the traders.

The dollar carry trade is currently on full-fledged. This means that money is flowing out of the US and moving into countries that provide attractive returns on various asset classes. Is this the reason why all asset classes are moving in one direction only i.e. upward? Equity and commodities have been rallying for several months now. Surely fundamentals have improved with pressures on the global economy easing but aren’t valuations looking stretched? Is this a situation of too much liquidity chasing these asset classes? One needs to answer the critical question of whether the economic recovery warrants such a quick run up in prices of the various asset classes. If not, it’s time to exercise caution as an asset bubble is being formed.

When the interest rate cycle in the US turns, it will be accompanied by an appreciation in the currency. That will create havoc in the financial system as traders will rush to unwind their carry trade positions. A downward spiral in the asset classes funded by traders will be witnessed and it will cause pain to the financial markets.

Also, we cannot deny the fact that the dollar as a currency commands immense investor faith and we all fend for it a situation of crisis. If any such situation were to arise, you will find traders of carry trade running for shelter bringing about carnage in several asset classes.