hxxp://www.dismally.com/2007/06/a_treatise_on_the_carry_trade.html
We seem to be at an interesting period with the carry trade. There are some winds of change that are brewing, and I'm not so sure that the carry will carry on. We all have to agree that at some point, regardless of the circumstances, the carry will unwind. But, what would it take to get that started?
In order to understand what might unwind the carry, first, look at what makes the carry. To begin with, in order to determine a yen cross rate, say the GBP/JPY, you have to multiply GBP/USD times the USD/JPY. That's the way the market determines the exchange rate of the crosses, off of the majors.
Looking at the past few years, interest rates here in the U.S. have been lower than other countries, thanks to Greenspan. Because of that, investors around the world have favored other country's interest rates, and the USD was subsequently sold off.
At the same time, Japanese interest rates have been sitting on the basement floor for what seems to be about a century. Japanese investors have been searching for yield all over the world in response to that. By shunning the USD in favor of other countries, and by selling their own currencies in order to invest these funds, the JPY has fallen to historic levels across the board. And the thing that is the "carry trade" was born.
One of the main reasons that the carry trade has perpetuated is due to the fact that there is a great deal of stability in the financial markets. In fact, if you were to look at equity markets this time last year, and compare them to currency markets at that time, you'll notice a similarity. Around a year ago, the carry really started to take off. At the same time, so did our financial markets. And in both cases, save for a couple of hiccups here and there, it's been the same story... higher and higher we go.
But, just last week, something different happened. The USD has been getting a bid tone over the past several session vs. the majors. If you take a look at the 10-year yield, you'll notice that right around the middle of May, the yield started climbing until it finally broke the 5.000% level just last week. And wouldn't you know it? The dollar, for the most part, started to climb around the same time vs. the majors until it really smashed through some levels just last week.
Coincidence? I think not.
There are basically three things that have perpetuated the carry trade to the levels that it has achieved: Stability in the financial markets, low interest rates in Japan, and the USD falling out of favor with investors due to yield differentials elsewhere.
But, wait a second... the US yield differential has changed, and now all of a sudden, investors are no longer scrapping the greenback.
In that scenario, I don't see any reason why the carry should crumble. Remember: In order to determine the yen cross rates, you take the majors vs. the USD and the USD/JPY, and multiply. So, although the USD has rallied vs. some of the majors, the USD/JPY has kept the carry going by moving higher. As long as USD/JPY remains lofted and pushes higher, regardless of the major's moves, it should hold the carry up.
But, there are fundamental reasons why the carry perpetuated. The most notable is that the U.S. interest rate outlook was low compared to the rest of the world. And now that's changed. Which means the fundamentals pushing the carry have changed. The USD should continue to see a bid against the other majors. This isn't necessarily because the greenback is back in favor as much as it is that there aren't any more reasons to sell it.
As I mentioned before, there are three things that are keeping the carry going. What's also interesting is that the other two elements are in question as well. But, in order for the carry to really come apart, we need a catalyst. And, what's really interesting is that when you look at the one element that has changed, higher interest rates in the U.S., you actually find the one catalyst that could push the carry over the edge.
You see, as much of a draw as the newly printed numbers on the 10-year are to investors, they are a bane to equity markets. The past few session's equity market movements suggest that things are going to be settled out, and it's all systems go. But, we have two key pieces of data coming in this week, CPI and PPI. If either of these do the same thing that the GDP inflation numbers did just two weeks ago (move higher), then equities are going to get a little sketchy.
As well, there is an interesting conundrum that is about to unfold, and that will likely have some profound effects on the world's markets. Sure. The U.S. economy is poised for growth going forward. But, growth usually means higher resource costs. And, we're already at the higher end of the threshold for the Fed to be sleeping soundly at night.
No matter how you slice it, equities are not going to perform well. Not when they are staring higher interest rates right in the face.
Also keep in mind that there was one thing that coincided with the carry trade: Equities markets moved higher as well. If we start to see some uneasiness in the equity markets, we may very well see the one catalyst that could bring the carry down. You bring the carry down, and unfortunately, you bring the equity markets down with you. Sadly, all of the foreign money invested in our bond markets gets sold off as well, and then we get even more interest rates.
The last element that could affect the carry trade is interest rates in Japan. We know that the BoJ is going to raise rates. What we don't know is how far they are likely to go. I doubt we'll see beyond 1.000% for the year. But, that is the start of the end of the carry.
For now, I am very weary of the USD/JPY rate. We're stuck between 121.00 and 122.00. We break to either side, and then we'll know pretty much how the summer is going to play out with all of the financial markets. But, I'm leaning towards the 121.00 level going. And that could be big.
