USD Carry Trade

A currency carry trade is defined as a leveraged cross-currency position built-upon an interest rate differential that is targeted to higher expected risk-reward transactions. The aforementioned trading strategy consists of borrowing low interest currency capital and investing in currencies with higher interest rates. Alternatively, the borrowed currency capital could be invested in various classes of assets with a superior perceived return. Normally, carry trades would be limited opportunities, as long as the markets react efficiently and quickly close the existing window of arbitrage. However, carry trade strategy does violate one of the fundamental theories that govern the foreign exchange market: the uncovered interest rate parity (UIP). According to the theory, UIP states that the expected change in the spot rate must reflect the interest differential between two currencies. The same theory predicts that the country with the high interest rate will witness its currency depreciate.
San Francisco Federal Reserve Bank President Janet Yellen said that “We should be monitoring asset prices for signs of bubbles. My views on that have changed because of the global recession.” European Central Bank Governing Council member Axel Weber also claimed last month that the financial crisis taught central bankers they cannot afford to ignore wild asset price developments. Yet even though global stocks have risen some 70% from the March lows, officials in the advanced economies are saying they do not see asset bubbles brewing yet. That position seems to be in contrast to the China view that largely puts the blame for rising asset prices at the door of low US dollar interest rates fueling speculative investment – the so called dollar carry trade. To mitigate the asset bubble risk, Singapore in September acted to cool the property market by releasing more land and making it harder for home buyers to defer payments. Hong Kong’s central bank has said it would cap the mortgage limit for luxury property at 60% and limit loan values. But China with its currency pegged to the dollar and its economy awash with bank loans is already some way down the road of building its own asset bubbles, blaming the US is not going to solve them. It is obvious that the low dollar interest rates have played a major part of the leveraged speculation.
All financial institutions – investment banks, hedge funds, pension funds, are borrowing dollars at near-zero rates and speculating in global markets, creating bubbles in many economies, rather than lending the money to consumers and businesses. The process is called the “carry trade” and it used to be a Japanese yen phenomenon for the last decade or so. Now gamblers are doing it with dollars, thanks to extremely low rates and the Federal Reserve’s policy of buying paper to keep long rates lower. In the meanwhile, FX speculators are shorting the US dollar which translates into a negative effective borrowing rate of at least minus 10% per annum. The FED’s monetary policy is forcing other central banks to lower their interest rates, hence the asset bubble keep growing exponentially. The longer the carry trade the larger the asset bubble and therefore the bigger will be the asset bubble crash.
Among many commodities, gold is benefiting from the world of a zero-yielding dollar, crossing $1,200 per ounce on December 4th. Some investors buy higher-yielding currencies, such as Australian dollars, New Zealand dollars and Brazilian real. Others prefer buying gold without taking currency risks. Gold has risen more than 30 per cent in the year to date, while an index of the US dollar [UUP] has fallen more than 10 per cent during the same period. The million-dollar question becomes: when will this unwinding process start? That moment would mark the next turning point in the dynamics for USD.