Dollar Rising: So Why Does The Carry Trade Continue?

Posted by urbandigs

Thu Mar 25th, 2010 11:11 AM

A: High yield bond funds continue to be en fuego, as investors rapidly pull cash out of low yielding Money Market funds and search for higher yield. The go to place clearly has been equities and high yield bonds; and any other asset classes that present higher yields. Make no mistake about, this IS the fed's desired environment to help recapitalize the banking system; wall street is simply doing their thing and playing the game to enormous profits. But how could the game continue if the funding currency staged a noticeable rally against other major currencies in the past 3-4 months?

Can we really dollar carry trade our way out of this mess? By looking at the markets over the past 13-18 months you may start to get convinced! What began as a seizing up of secondary mortgage markets and plunging bids for securities tied to mortgages, has ultimately morphed into a historic carry trade driven rise to reflate asset prices. Looking at the $900bln or so decline in Money Market Funds (MMFA Index) over the past year shows you this drastic search for yield (view image).

When you have such a liquidity driven carry trade in play you can't control where the added liquidity ultimately finds a home. That is the essence of what we have seen in all asset classes over the past 12 months. The money has been flowing into any asset class that presents a yield (mainly HY corporate bonds and equities); and its the higher yielding asset classes that saw the most historic rises. But the driving force of this movement of money by mass injections of liquidity/fed guarantees is artificial and unsustainable; yet the effects are immediate and dramatic. This is partially the goal of the fed: to reflate asset prices and recapitalize our banks that still have questionable marks on complicated illiquid and often hidden securities on their balance sheets - some call it extend & pretend.

But the question of control comes to mind and it is no surprise that wall street takes this to an extreme level, trying to cash in as much as possible while the game is on. That is, the game is very profitable and works only until it doesn't anymore. From NY Times "Regulators Tackle ‘Carry Trades’":

But near-zero interest rates in the United States last year saw the dollar become the financing currency for these trades. The big problem with currency carry trades is that they are inherently unstable. Although they can prove lucrative for short-term players able to get in and out of positions quickly, they fly in the face of basic interest rate theory.

The initial buying of the high yielder has the perverse effect of pushing the risky currency higher — giving the impression of a one-way bet and complicating policy for any developing country, as the overvalued exchange rate hammers the country’s export competitiveness. The situation can persist for several months and even years, but the unwind is then all the more sudden and vicious as the leveraged positions all head for the exit at the same time.
chart-dollarindex.gifWhich brings us to the recent rallying US Dollar. By looking at the US Dollar Index chart to the right, you will see that the greenback has actually strengthened noticeably against other major currencies; mainly due to EURO risk aversion with the PIIGS worries casting a cloud over investors. Which begs the question: IF THE FUNDING CURRENCY HAS RISEN SO MUCH IN SUCH A SHORT PERIOD OF TIME, HOW CAN THE ASSET CLASSES BENEFITING FROM A DOLLAR CARRY TRADE MAINTAIN THEIR AGGRESSIVE UPTRENDS?

And herein lies the confusion of many. The thinking goes, if the carry trade is helping the banks to recapitalize and is reflating assets in the meantime for investors to trade on then who the hell cares if another asset bubble is forming somewhere or not? Here is an excerpt from an industry insider regarding this exact topic of conversation:
"The vast majority of HY and equities are in USD anyhow so the FX component is not too relevant. It would really only matter to investors overseas investing here and vice versa.

The carry trade that's on now has nothing to do with the FX carry of old. It's that a US bank can have illiquid assets on it's books at 40 when they are worth 10. They just make $10 a year for 3 or 4 years and write down the investment a little bit more each time around while still able to show a profit. So long as nothing drastic happens eventually they'll have it written down to market. That's why even if you bid 15 for it you can't get them to sell it. Yes the carry trade is on, but if banks can earn their way out then who cares?"

Just keep the game going as long as the fed or the markets don't do anything crazy to disrupt it! And that is a story we all heard before and we all know how the game ultimately ends.

I look for signs of a carry trade unwind daily and to see the funding currency rise makes me wonder if it has started? But with HY and equities marching on, how could this be?

What are your thoughts?