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The Decoder: Carry Trade


Complex financial topics explained.

Editor's Note: Welcome to The Decoder, a regular series that will explain some of the more complex financial and business topics in the news. If you have a topic you'd like decoded, let us know in the comments.

There's been an escalating hum of chatter recently about the dollar carry trade, and what its effect might be on the US economy and the value of the greenback, which is the world's reserve currency.

So what is carry trade, anyway?

Although it can refer to other asset classes, carry trade is an investment strategy most commonly used with currencies. It's essentially a bet that one depressed currency will remain low, or will even fall further. In that sense, it's often considered the equivalent of shorting a currency.

Here's how it works: When interest rates are low, as they are in the US right now, it doesn't cost much to borrow money. Carry-trade strategy usually involves borrowing one currency at a very low rate and investing it in another country where interest rates are higher. The difference between the two rates is your profit.

Easy, right? It can be, but there's an element of risk. The investor is essentially betting that the currency he borrowed will remain weak. If it gains strength, he risks erasing some or all of his profits on the deal.

Carry trades can backfire in a big way. In Iceland, where interest rates were in the double digits before the crash, speculators borrowed in euros or yen and invested in Icelandic assets. The carry trade essentially turned the tiny Nordic country into one overleveraged hedge fund. When its economy imploded, those Icelandic assets collapsed and carry-trade speculators ended up in debt.

The Japanese yen has been a common currency used in carry-trade strategies in recent decades as the interest rates there have remained low. But in 1998, when the Russian ruble collapsed and Long Term Capital Management blew up, the yen surged by 20% in two months, putting the yen carry trade in peril.

But now, there are signs that the US dollar is the new Japanese yen when it comes to carry trade, and that's a bit troubling.

For starters, no one really knows how big the carry trade is in any currency at any given time. There's been enough anecdotal evidence in recent months that hedge funds and other governments are indeed employing a dollar carry-trade strategy. Just like any other shorting strategy, the more who play the game, the more likely the dollar will remain depressed.

Germany, Abu Dhabi, and Sweden have all recently borrowed dollars in carry trades. Even Hugo Chavez has caught on. As reported by Barrons, the Venezuelan government recently issued $3 billion in dollar bonds, with the hope of paying back the debt in further devalued dollars. Some view that as a sign the dollar has bottomed.

When the yen was commonly used for carry-trade strategies, the US was a big beneficiary of investment dollars. When the dollar is used instead, those investments are going elsewhere, which is detrimental for growth in the US economy.

The Federal Reserve, of course, is hoping to spur economic growth by keeping interest rates low. But the pressure on the dollar comes at a time when officials from China to Russia are calling for an alternative to the greenback as the reserve currency. The Obama administration is adamantly defending the dollar's role in the global economy, but as rates remain low and the dollar weak, that will become an increasingly difficult argument to make.

But the dollar carry trade isn't all bad news for the US. The dollar historically moves in the opposite direction than the stock market -- as the Dow has soared in the past six months, the dollar has dropped. If the dollar remains weak, chances are good we'll still be enjoying a strong stock market. But if stocks fall, as many bears are expecting they will, the dollar should gain strength again and this dollar carry-trade strategy will no longer be viable.

And a weak dollar also gives a boost to large US companies that generate a lot of revenue from overseas, such as General Electric (GE), Coca-Cola (KO), and Intel (INTC).
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