Is the carry trade the way forward?

As a fixed income guy, it's entertaining it see the the S&P go up all the time as the bond market resets from the major losses of the last half of the year. Here's the hitch with the consensus view on the bond market.

For many of you who do not know, borrowing in a low-interest market to attack countries with loose capital controls is something that helped bring about the Great Depression in 1929 - for those who do not believe me, read Barry Eichengreen’s book, Capital Flows and Crises, it explains the role capital outflows which could have created a small sneeze on the German and British economies morphed into deadly contagion with dire, infective power as investors looked for one thing to profit from this: carry. Now, today’s carry trade carries many hidden long-term risks.

So generally, the carry trade is now a play off of an America moving forward in the direction as neither a world, reserve currency or as the most important economy in the world. Due to our inverted world, negative job data means a higher market because of more Q.E., the carry trade becomes a measure of support for the Federal Reserve to maintain its tourniquet that has become a noose around patient with just a soft nosebleed. It strangles an economy through unintended consequences, especially over the long-term, and with many people discounting their portfolios in favor of low-interest rates running through 2014. It’s as Scott Minerd, CIO of Guggenheim Partners, wrote in his August 2012 article that we have now become characters in an ugly Faustian drama.

Thanks to the Fed, a once majestic and regal empire now prints an absolute plethora of paper money which falls short of fixing anything, and instead worsens the country’s financial woes as it unravels and descends into chaos. Thanks to the carry trade we can now get on this band wagon too.

So you think the carry trade signals a market downturn?
Let’s look at the logic of the proposed carry trade. The trade requires the belief the U.S. economy cannot grow significantly, it requires another view that the trade (since it is only possible with relatively low volatility currencies like the USD or JPY) will devalue over time in parallel with the national economy’s lack of growth and investor’s lack of confidence. That's why some call it the last trade to hell.

Lastly, for the trade to be effective, it means that the Q.E. many believe necessary for the U.S. economy to keep going on life support will eventually hinder hard won victories by Abe and Abenomics in Japan, as investors flock to the yen and their imports, which to decrease was a hallmark of their policy, increase. Remember, as one mentor of mine always says, 'The road to hell is always paved by intentions in monetary policy.'

Further Fed action until Yellen's appointment before the December meeting will have a negative impact around the Northeast Pacific region, which is resolutely dependent on a stronger Japan jump starting their growth before the end of the year, and will come back to hurt the American economy later on as the tapering decision is put off. Insiders I spoke to at the BoJ last week are quite worried about this; in fact this is the top concern.

 
Best Response

Yen has been very inversely correlated with the S&P lately - yesterday (5/20 was a prime example. People were borrowing yen to buy US equities (carry trade); as stocks tanked, yen got short-squeezed. Short interest on yen futures is still as high as ever, though the carry trade may now be into UST.

You also need to remember that although Japan has shoddy fundamentals, it is experiencing deflation, which makes real interest rates relatively high (ie - you get paid for holding yen). Parity does tend to hold over the long-term, which implies that inflation is the primary factor behind currency moves - this is yen bullish.

I'm still bearish on the yen because most Japanese public debt is held domestically, and Japan already has a very high savings rate. The only bullet left in Japan's arsenal is a foreign debt offering, and I think globally, they'd get pummeled.

I'd avoid being on either side of the yen carry whilst volatility persists.

 

Thanks for the detailed response yesman. I'm still not sure I follow fully.

You said that people were in yen carrys to buy US equities, but then the market tanked, forcing a short squeeze on the yen. How would this have caused a short squeeze on the yen? If everyone was selling back their yen, wouldn't the price have decreased rather than been squeezed upwards?

Thanks again

 

Your misconception is the following:

If you do a carry trade, you borrow Yen e.g., i.e. the low-interest rate currency, and invest in a high-yielding currency, or in risky assets in another currency - anything is possible. Borrowing Yen is like selling it short, making its value decrease against the USD e.g. If there are many carry trades on the Yen, it's value decreases. If all these positions are covered again, so that the outstanding Yen-loans are covered, yu have to buy Yen to cover your position - this increases the value of the Yen.

You see the point?

 

Great Ezekiel, thanks. This explains why the yen rose vs. the australian dollar this week as everyone was selling their austrlian dollars and buying yen.

Thanks

 

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