HELP WANTED: CARRY TRADE

[victor]

hi all,

Recently I've read a quite interesting article about the carry trade. It was on John Mauldin's Newsletter "Outside the Box", and it was written by GAVEKAL FIVE CORNERS.

Here is an excerpt:
"Every now and then, central banks fall asleep on the job and allow their currencies to achieve very overvalued levels. In turn, this slows down the underlying economy, a fact which then forces the central bank into cutting rates aggressively to counter-balance the tightening done by the FX markets. When such a turn of event occurs, financial market participants jump on it with both feet; all of a sudden, financiers are given an opportunity to borrow in a currency which a) goes down and b) whose borrowing costs keep falling. What we are describing above is not theoretical. In fact, it has happened twice in the past decade. And it is about to happen again. A fact with important investment consequences."

So, anyone out there knows where I can find more information about the process described above?

Thanks.
Best regards.

Victor

[SRmanager]

I was cleaning up and I came across an article titled "Cheap Yen Plus High U.S. Rates Equals the Infamous Carry Trade"

It is a bit technical but it explains step by step how the short JPY carry trade was done. I don't know how to attach a PDF file to this post, but if someone is interested, please send me a private message.

[nodoodahs]

It is very difficult to track trades like this. A very simple transaction: I borrow $1mm from Wells Fargo in US$ and park my money with HSBC in London in British Pounds. The Pound goes up and HSBC in London now has more reserves in its "vaults" and therefore can lend out more money - thus increasing the money supply. Conversely, there are less reserves now at Wells Fargo, and since what they lent out isn't deposited into an American bank, they money supply cannot multiply. In fact, the money supply now shrinks since American banks will have $1mm less cash to use to increase the money supply.

I'm fascinated that the borrowing of the shorted currency is anti-inflationary (in the monetary sense) and would tend to lower prices domestically while increasing prices for imports.

Some would theorize that the relative reduction in currency circulation would increase the purchasing power parity of the dollar in your example. More evidence IMO of the failures of PPP to predict ForEx changes.

A monetarist view would be to predict future exchange rates by monitoring the relative changes in money supply with the higher growth currency devaluing, but this example (and my own analysis of US/UK/Euro) runs counter to that.

I had theorized that the connection between US M3 growth exceeding EU M3 growth while the USD appreciated was due to M3's "steroidal" affect on the US economy and stock market, but your example suggests it was the carry trade, at least in part.

It does make a statement in support of interest rate parity as a predictor of exchange rates, though.

Apparently the source of profits is 1 part interest rate differential and 1 part borrowing a depreciating currency (which is self-fulfilling if enough players are doing it). Many hedge funds did the same thing by borrowing gold at (IMO intentionally depressed rates) from central banks and buying treasuries with the profits, thereby lowering the price of gold even further. The GATA folks are big into talking about this.

I like how you phrase it ... a "simple transaction." How does one borrow the $1 million? How does one park the money in Pounds? Is it as "simple" as buying foreign treasuries (which doesn't seem that simple to me)?
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

A Forbes article on the yen and dollar carry trade from May 2004:

http://www.forbes.com/2004/05/26/cz_do_0526hedge_print.html

It is very difficult to track trades like this. A very simple transaction: I borrow $1mm from Wells Fargo in US$ and park my money with HSBC in London in British Pounds. The Pound goes up and HSBC in London now has more reserves in its "vaults" and therefore can lend out more money - thus increasing the money supply. Conversely, there are less reserves now at Wells Fargo, and since what they lent out isn't deposited into an American bank, they money supply cannot multiply. In fact, the money supply now shrinks since American banks will have $1mm less cash to use to increase the money supply.

Put commodities, equities, derivatives, etc., into the whole picture and you have one messy picture. At the end, we can only guess (by watching certain currencies or commodities go sky-high or watching emerging market spreads narrow) - and we won't really, really know until we see a hedge fund blowup of some kind.

Take another simple example. Oil has appreciated nearly $20 in 12 months. How much of that is due to real demand and how much of that is due to inventory building - the overconstruction in the manufacturing sector or in the real estate sector, and so on, in China? How much of that is due to hedge fund speculation? And we haven't even gone into the supply side yet - since OPEC data is so opaque. In the end, we're all guessing - including the folks from the EIA and certainly folks who are regarded as "specialists" in the oil and gas fields, including Matt Simmons.

[nodoodahs]

What I really wanted was information about how the process is executed, and more important, how the things look like at the very beginning of the carry trade.
Let's take the dollar carry trade. I can imagine that when it started, (+/- year 2000) the dollar was overvalued, and the Fed were pushing rates down.
Well, I don't want to imagine. I want facts. So, does anyone know any article/book/newsletter/... about the carry trade?

I like the way you think ... I'll be watching you ...

Not only what it looks like when it started i.e. conditions appropriate for initiating a carry trade, but how they manage the transaction. And, if possible, clues as to ascertaining the process is happening! Does carry trade show in flow of funds data, in monetary aggregates, etc? If so, how do I (as a small investor) hop along for the ride?

Henry mentioned you needed volume and liquidity in the currency (or in the treasuries?), and that UK pound, US dollar, JP yen, and EU euro were the only ones that fit the bill on a "global hedge fund" scale.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[victor]

Thanks to all,

With my first post my intention was not to make a quizz show just to find out which were the countries involved in the carry trade. The article (and the facts) make clear that they were the yen and the dollar.
Thanks tifosi for posting it I wasn't able to find it in the web.

What I really wanted was information about how the process is executed, and more important, how the things look like at the very beginning of the carry trade.
Let's take the dollar carry trade. I can imagine that when it started, (+/- year 2000) the dollar was overvalued, and the Fed were pushing rates down.
Well, I don't want to imagine. I want facts. So, does anyone know any article/book/newsletter/... about the carry trade?

I want to research on myself the conclusions given from GAVEKAL. This is, the chances to face a new carry trade with the euro.

Thanks again.
Victor

[SRmanager]

I understand his question now - he was asking about specific trades!

In that case, the short JPY and USD have been great against the AUD, NZD and EUR.

I don't buy GaveKal's new carry trade with short EUR. Not yet at least...

[Tifosi]

Folks,

Here is the entire article. As you will note at the very bottom, the new carry trade is with the Euro, which is expected to drop.

You can find it at

http://www.investorsinsight.com/otb_va.aspx?EditionID=153





Out With the Old, in with the New Carry Trade

Every now and then, central banks fall asleep on the job and allow their currencies to achieve very overvalued levels. In turn, this slows down the underlying economy, a fact which then forces the central bank into cutting rates aggressively to counter-balance the tightening done by the FX markets. When such a turn of event occurs, financial market participants jump on it with both feet; all of a sudden, financiers are given an opportunity to borrow in a currency which a) goes down and b) whose borrowing costs keep falling. What we are describing above is not theoretical. In fact, it has happened twice in the past decade. And it is about to happen again. A fact with important investment consequences.

Between 1995 and 1998, a number of investors participated in the great "Yen carry trade". For three years, it was fantastic: whatever one bought with one's borrowed Yens, one made money. Until one did not; and then the unwinding of the Yen carry trade was both violent, and painful for those involved in it (Tiger, Sumitomo...).

From 2001 to 2004, we experienced the great US$ carry trade. As we tried to show in a number of reports in the past couple of years a large number of people borrowed US$ on the premise that a) the US$ could only go down and b) borrowing US$ was nearly free (1% interest rates) and likely to stay that way for a very long time.

Needless to say, the US$ carry trade is no longer working. For a start, the US$ is no longer falling, and borrowing US$ is no longer free (the Fed just raised rates again). In turn, this raises an important question: will the unwinding of the US$ carry trade prove as painful as the unwinding of the Yen carry-trade?

As our readers know, we have argued in recent months that the unwinding of the US$ carry-trade could lead to some short-term dislocations in the financial markets. However, so far this year, the US$ on a trade-weighted basis has risen +11% in a straight line, and the impact on financial markets has been mild. So have our fears on the effects of the unwinding of the US$ carry-trade been excessive?

One explanation for the good tenure of markets in the face of the US$ rally is that most investors short the US$ (save the ones who got in the game late) are still positive on their short US$ trade. Meanwhile bearishness on the US$ remains prevalent (i.e.: the belief in the "unstainability of the US current account deficit), and so panic has not yet hit the market.

This could of course change as central banks all over the world, except in the US, start to loosen monetary policy. Sweden and Poland have already cut interest rates by 50bp; and we believe that the UK, EMU & Australia should soon follow. As Charles put it in a meeting recently, this is the first cycle in his memory where the Fed is likely to be the last central bank to stop raising rates; and the last central bank to cut rates (if and when it does). The widening interest rate differentials alone should trigger an impressive US$ bull market.

As this reality of the US$ bull market sets in, we will of course witness a change of behaviour in financial market participants. Will this change be a panic? Or will the change be a hunt for new opportunities? We use to believe it would be the former. We now believe it could be the latter. Indeed, all around the world, it is becoming increasingly obvious to investors that there is one currency which remains grotesquely overvalued, and whose interest rates can only go down: the Euro (though the AU$ also qualifies). So borrowing Euros to buy whatever else now makes a lot of sense. The US$ carry trade is in the process of being replaced by the Euro carry trade. This means, of course that we should expect the Euro to fall like a stone.

[HenryTo]

SRManager,

I think what the author was discussing was the Yen carry trade which lasted from 1998 to 2001 and then the Dollar carry trade which lasted from 2001 to 2004. Besides the British Pound, only these three currencies are "liquid enough" for the hedge funds to do a carry trade on a worldwide scale.

Best,

Henry

[SRmanager]

I suspect they are talking about the currency crisis in Latin America and Asia if it was in the past decade?

Someone more familiar with these trades should comment.