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Minyan Mailbag: How Is The Carry Trade Actually Done?

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...in essence the world is massively long the dollar and short the yen.

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Prof. Succo,

I understand the premise of the carry trade, borrowing in a country with low interest rates, and lending in a country with higher rates, however, how is this actually done? Doesn't the act of buying the currency you wish to lend in and selling the currency you're borrowing reduce the interest spread, i.e. your profit margin, between countries? If so, then how do you make money on this? Or is there a "credit" component to this trade in the country you are lending in that makes this profitable?

Second, with regards to your ongoing articles regarding Central Bank liquidity creation, aren't the money center banks cognizant of the central bank(s) policies of money creation as you described? Wouldn't they be at all concerned about this, since it's their industry that is in jeopardy? Or is the competition amongst investment banks and providing shareholder returns so intense that no one is really paying any close attention and no one really wants know why the Fed is doing what they're doing?

Lastly, what about the leaders at the other Central Banks, why do they continue to accommodate the US Federal Reserve with their liquidity creation policy?

Minyan Robert


MR,

If one borrows in Japan and lends it in the U.S. at a higher rate, but then hedges the currency risk (you must sell dollars forward versus buying yen forward), the forward rates embedded in the currency hedge exactly offset the profit one would earn in the rate differential between the countries. There is no free lunch. The "carry" trade then as it is referred to must somehow lend at the higher rate in the U.S. without hedging the currency. So in essence the world is massively long the dollar and short the yen. Who would do such a stupid thing?

Why none other than U.S. central banks. I have explained the process before. The Fed creates cheap credit to the U.S. consumer and that credit is spent oversees in Asia. Asia, receiving dollars in trade, should then go into the market and sell dollars to buy yen. If they did this it would drive the dollar down and U.S. rates up. The Fed could no longer offer cheap credit as the market would not let it. Instead, Asian central banks are keeping the dollars and creating credit in Yen.

It is our friends in Asia who are massively long the dollar and short their own currency in a prolonged attempt to keep their currency cheap to continue to export to us (and lend).

When we speak of consumers or traders or banks or hedge funds long the carry trade it is in reality that they are borrowing cheaply and taking risk with it. They borrow money to consume, they borrow money to buy stocks, they borrow money to buy mortgages and they borrow to buy whole companies at aggressive terms.

The carry trade is central banks creating credit and huge foreign exchange reserves in astounding amounts and lending it out for private investors to take more and more risk with it.

On your second point I think you are correct: banks are taking more and more risk (and laying some of that off to private investors) in their lending practices due to high competition and pressure from shareholders and the Fed (the Fed has lowered margin requirements aggressively, thus signaling to banks to take more risk).

The leaders of central banks are bureaucrats. The current Fed make-up is 86% academics with little market or business experience (at least under Greenspan it was 50%). They are under great pressure to keep economies chugging along and just like politicians they put off any pain to the next regime. Just look at Thailand. They prudently became concerned at the amount of speculation being created by loose policy and tried to raise margin requirements. Their stock market traded off 15% the next day. I assume they were quickly taken out to the shed by more "powerful" central bankers from other countries. The next day they reversed their decision and markets rallied.

The world is hooked on free credit.

-Succo
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