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FX Research - The dollar as a funding currency for the carry trade? I don't think so.

The dollar as a funding currency for the carry trade?  I don't think so.

 

I get all sorts of questions from traders and the press in a given day and the one I heard once again is will the USD become the funding currency for the carry trade, elbowing past the Swiss franc perhaps now that Fed funds are targeted at 2.25% and SNB Libor target is 2.75%.  Well if the carry trade were only about interest rate differentials it would be case closed…the dollar is number two in the carry funding world after the yen with BoJ overnight call rate target at 0.50%.  Moreover, with the Fed set to cut rates more in April, the funding appeal of the dollar is only going to be enhanced.

 

A low relative (nominal and real) rate is a necessary but not sufficient condition to support the carry trade.  Low volatility is the sufficient condition – benign capital markets – and we are in a high volatility world and capital markets are anything but benign.  The carry trade seeks to maximize interest rate differentials and it works best when there is relatively low volatility in both the funding (short) and lending (long) currencies.  Sure the carry trade works if the funding currency is in a downtrend and the USD qualifies in a very long-term sense (6-yr downtrend), but is a record low in the dollar index the place to set up carry trades where risk reversals carry a premium?  Add volatility into the mix and the carry trade becomes highly unpredictable – look what would have happened to positive carry from being long Aussie and short USD last week –AUD fell almost 4% versus the USD which would have taken many carry aficionados out of the trade.  Indeed Aussie/yen in the last eight months has done little for those long carry.

 

And throw in a credit crisis where finding financing for trades is becoming increasingly dearer as the sell side hoards cash in the face of elevated funding risk and unprecedented write downs of assets.  Cheap and stable sources of credit are key to running a large leveraged carry trade.  Current financial market anxiety is an anathema to financing the carry trade.  I also can’t help but think that the hoarding of dollars by the sell side as banks prefer cash balances over risk tells me the dollar is serving other purposes currently that trump any appeal of running a large dollar funded carry book. 

 

When the Fed took Fed funds rate to 1.00% in 2003 and held them there for a year before beginning a tightening cycle there was no mention of the dollar as a funding currency in a carry trade despite higher nominal and real rates elsewhere.     

 

I suspect that the yen carry trade is amongst the many victims in the credit crisis - a wooden stake driven through its heart on a number of occasions and while Japan’s economy and currency have zombie-like characteristics, the carry trade is not likely to make a significant return from the dead in the period ahead.   If it ain’t working for the yen, it surely ain’t working for the dollar.

 

David Gilmore  



 

 

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