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Thursday February 23, 2006 - 15:42:47 GMT

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The end of carry trades?

Global liquidity conditions will be more restrictive during the next few months as central banks continue to tighten policy. It is particularly significant that there is likely to sustained monetary tightening in the low interest rate areas of Japan, the Euro-zone and Switzerland. In this environment, there will be reduced market interest in carry trades and the risk of a downward shift in prices, especially with a reduction in existing positions. A period of rapid adjustment should not be ruled out given the extent of inflows over the past year.

In this environment, there is likely to be reduced selling pressure on the Euro, Swiss franc and yen as currency demand increases. The US dollar and Treasuries could see some safe-haven demand, but there is also likely to see a net reduction in dollar buying interest which will tend to weaken the US currency.

From a longer-term perspective, there is the possibility that market tensions will set the scene for a sharp slowdown in global growth. There will be the potential for a reduction in interest rates late in 2006 as inflation fears disappear rapidly, especially if commodity prices fall sharply.

Yield investments have dominated

Carry trades have been a very important feature of currency markets over the past six months. Funds and, increasingly, individual investors have borrowed funds in low yield currencies to invest in high-yield currencies and speculative assets. The target investments have included currencies such as the Australian and New Zealand dollars as well as emerging market instruments such as the Brazilian real and Mexican peso. Commodities and energy instruments have also benefited from the trend which in turn have boosted the Canadian dollar.

Increasingly, the US dollar has been seen as an attractive destination for short-term funds as the Federal Reserve has pushed short-term interest rates to 4.50%. The currencies most vulnerable to selling pressure have been the Japanese yen, Swiss franc and Euro due to their low yield structure with the yen particularly vulnerable given that short-term interest rates are at zero.

Market stresses start to increase

Over the past week, there has been increased evidence of a reversal of the trend. As is often the case, signs of a changing trend have been seen in markets which do not normally receive significant media or investor attention. The 1997 Asian currency crisis, for example, started with a run on central bank reserves in Thailand before spreading to the more major regional markets. Smaller markets are particularly vulnerable to sharp price adjustments as they do not have the trading volume or liquidity to absorb any big increase in selling. As a result, prices have to adjust rapidly which in turn increases the risk of cascade selling.

In this case, the tensions have been sparked in part by a sharp drop in the Icelandic krona or crown. Iceland has been a beneficiary of investment flows, helping to support local asset prices and Icelandic investment overseas. A ratings downgrade by Fitch due to debt concerns resulted in a sharp market correction with the currency weakening close to 10% against the Euro over a 48 hour period. The sharp drop in the currency also prompted significant weakness in currencies such as the Brazilian real and Hungarian forint. There was some evidence of position closure to offset losses in Iceland and wider position capitulation was also a risk as prices moved quickly.

The butterfly effect

Over the same period there has also been a significant moves in major currencies with a recovery in the Japanese yen against the US currency to 116.90 from levels near 119.0 while there have been sizeable losses in the New Zealand dollar. Students of chaos theory will inevitably show a strong interest in the fact that a credit downgrade in Iceland can help trigger significant dollar losses against the yen. It is the case that there are important market linkages, primarily reflecting the leveraging of positions and impact of carry trades, although it is also the case that the New Zealand dollar selling was already an important market feature before this week as there was a drop in New Zealand yen-denominated bond issuance.

There is now likely to be speculation that there will be a wider adjustment of positions and an end to the aggressive carry trades seen over the past few months. It is certainly the case that global conditions are changing and the adjustments are likely to continue over the next few months which will have an important impact on the currency markets.

Monetary conditions tighten

The ECB increased interest rates by 0.25% in December to 2.25%. There is a very high probability that there will be another increase at the March meeting with the potential for further rate increases over the next few months. The Bank of Japan has also signalled that it is very close to ending the quantative monetary policy that has been operating over the past five years to combat deflation. Opposition to a tightening from the government is fading and the central bank is likely to tighten within the next six weeks.

With the US Federal Reserve also raising interest rates, the growth of global monetary creation and supply of liquidity will start to slow significantly. Although growth is still strong at present, there will be reduced opportunities for speculative carry trades as excess liquidity starts to disappear from the system. There will also be the risk of stop-loss selling on existing positions.

Buying opportunity?

In nominal terms, Japanese interest rates will remain low and there will still be a substantial yield premium on dollar and emerging-market yields. In the short term, therefore, any corrections will also be seen as attractive buying opportunities for high-yield assets and there will tend to be a fresh flow of investment funds.

There will, however, be concern that corrections will be met by substantial selling pressure as positions are liquidated, especially if price corrections stronger fail to exceed previous highs.

After a period when investment strategies have been dominated by a flow of funds into high yield currencies, it is likely that defensive currencies will hold greater attractions over the next few months.

Long-term impact

A significant proportion of speculative funds have moved into commodities and oil funds and the strength of raw material prices has been an important element in triggering global inflation fears. If there is a withdrawal of funds from commodities and a sharp downward adjustment in prices, there will also be a reduction in wider inflation fears. This could set the scene for a cut in US interest rates by the fourth quarter of 2006, particularly if the US the economy slows. Indeed, it is a possibility that deflation fears will return by late this year.


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