Why the Dollar Carry Trade Could Unwind
Keep an eye out for dollar strength: It could turn into a rout of selling in foreign bourses and make you wish you'd kept your hard-earned dollars here at home.
Liquidity is the one asset whose supply disappears as its price rises. This is why we get volatility spikes during stock market sell-offs and large gaps on the charts when the unexpected happens. If the present unpleasantness in global markets continues, look out for an unwinding of dollar carry trades and some real potential for an execution vacuum or two.
Very Wary of Carry
The dollar carry trade really moved to the global fore ahead of the yen carry trade once the Federal Reserve began its rate-cutting and money-pumping panics in August 2007. A carry trade is simplicity itself: You borrow dollars, sell them, buy whatever currency your little heart desires therewith, and then lend them in that currency. Your risks are that whatever you invest in could go down, and that the dollar will become more expensive when it comes time to repay your loan.
The big advantage that the dollar carry trade had over the yen carry trade is the yen had a disconcerting habit of getting stronger every now and then (see Why the Yen Carry Trade May Return). The dollar, under the fine stewardship of Messrs. Geithner and Bernanke ("A strong dollar is in the best interests of the United States, blah, blah, blah") did not seem to have that risk. More important, the dollar was and is the world's reserve currency, something the world should be embarrassed about, and that means whatever we printed we could shove down someone else's throat.
International finance has more in common with a monster truck rally than most people realize.
What happens when the assets financed with cheap dollars go down in price and investors sell them? The answer is that a sudden demand for dollars is created. The Bloomberg correlation-weighted dollar index has jumped more than 9% since the end of July. That, in turn, creates a buying panic; the volatility for three-month dollar forwards for euro-denominated investors has jumped from 11.9% to more than 17.5% over the same period. This has the makings of a vicious cycle.
The most motivated sellers are those who are trying to protect profits; there is no worse feeling than having a gain turned into a loss. If we map the average annual carry trade returns for the dollar into a range of currencies since August 2007, we see only a few are at a net loss. These include the Hong Kong dollar, the Korean won and the British pound. Some currencies, such as the Brazilian real and Australian dollars, still have a high open profit.
Many of these carry returns were much higher at the end of 2010 as the Jackson Hole sugar buzz was still coursing through the markets' veins. Keep an eye out for dollar strength: It could turn into a rout of selling in foreign bourses (I love the word "bourses") and make you wish you had kept your hard-earned and easily printed dollars here at home.
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