 |
The Carry Trade
With the USD's latest rise over the past couple of months and, in particular, the past week against the majors (excepting, perhaps, the Japanese yen), there has been more headline news about the "unwinding of the carry trade." So, what is this elusive thing known as the carry trade? The popular notion of the carry trade at a very basic level is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. The goal of this strategy is to capture the positive interest rate differential between the two country's rates.
There are two obvious risks to this strategy: material changes in interest rates and material changes in currency exchange rates. This is, in part, why the JPY has largely been used as the short currency to fund; it has the lowest interest of the G10 currencies and, thus, much less sovereign risk to factor in as part of the equation. But this is a very simplistic view. There are significant other factors that come into play — each country's equity and fixed income and money market levels, credit availability, the economic cycle, geopolitical factors, commodity risk, retail versus institutional participant risk, monetary policy, and political winds of change.
There are two very difficult things to really know about carry trades — how large and deep is the collective set of carry trades per currency and what exactly triggers an unwinding or trade put on. One thing is certain: when the consensus carry trade does unwind as a result of credit/cash need, as perhaps so last week, the unwinding tends to be noisy and turbulent. Let's look at the mechanics of the carry trade, possible causal factors, and the sometimes odd effect it has on exchange rates, such as the very recent strengthening of the JPY in the face of a solid USD rally.
Consider this example of a carry trade. First, there are two real types of underlying transactions that define the carry trade. The first is traditional foreign investors in equity, bond, and money market instruments attempting to achieve traditional money management goals of balanced financial planning, etc. The carry trade, here, is literally the dividend and or interest rate "carry" of their holdings. Traditionally, this was not necessarily lumped in with the more famous brethren of this trade: leveraging short-term loans of a low-yielding, interest rate currency into high interest asset investments. The reason to distinguish the two is that the former is a much broader interpretation of the carry trade — making it much more elusive as one would have to examine both the investment side (speculators, investors, governments) and financing side (which would include analyzing bank balance sheets to see trends in short term loan growth). The conclusion by many studies is that there is no evidence of the pure "popular," headline version of the carry trade; hedge funds do not admit to it, and there is no evidence of short-term yen loan growth or IMM positions growing its longs. But, for fun's sake, we will focus on the "celebrity" carry trade, which is shorting the low-yielding currency to buy a high-yielding currency and the unwinding, which is to merely close out the position (and, thus, we would theoretically see an ironic rise in the low yielding currency). We will use the ever popular JPY as an example.
Let's take Hedge Fund (HF) Investor borrowing six-month JPY back on March 3, 2008 at 1.02 percent and spot USDJPY at 103.49. HF Investor salivated at a 6 month NZD deposit rate at 9.1175 percent at a spot rate of .8066 versus the USD, (equivalent NZDJPY rate of 85.01.) With the potential of getting an 8.0975 percent excess yield, HF Investor decides to engage the trade by selling the JPY (lending) and buying the NZD (investing). It's now August 22 and USDJPY has strengthened to 110.07 and the six-month JPY yield has dropped a bit to .9450 percent, but the six-month NZD rate now stands at 8.2450 percent, a full .88 percent drop and the NZDUSD drops to .7088 with NZDJPY cross fallen to 72.08.
Now, a few details to fill in between before we get to the "oops" moment: first, global equity markets saw huge rises early in 2008 along with commodity price gains helping countries like New Zealand; then the U.S. credit crisis version two hits in late March, knocking off all values but global central banks are forced to raise rates to fend off inflation. Then the U.S. slowdown feeds into a full scale global slowdown, the ECB signals it is stopping its rate hike cycle, the Fed retains an ease posture, commodity inflation peaks in June/July, and that small bubble bursts in August as a result a drop in crude oil from a high of 146.57 to the a level of 112 by end the of August. The NZD drops like a stone, as do interest rate differentials. So, what happens to our investor?
Based on a $1MM USD equivalent trade in a six-month instrument using JPY as the lending source and the NZD as the invested asset (and assuming the investor holds until expiration of this six-month investment), here is what we have (in USD equivalents): interest rate proceeds gain of $89,750, currency conversion loss of $179,384 — or a net loss of $89,634 or -8.963 percent. This is not the +8 percent excess yield as expected. Add to this the fact that HF Investor knows this is happening along as he or she values this investment/trade daily and watches the losses grow and nerves fray. Add to this the fact that, perhaps, HF Investor might have other losses as a result of equity and or global fixed income holdings being scorched by inflation over the past year and may be forced to liquidate certain positions around the end of August. Add to it the fact that maybe there are thousands and thousands of investors like HF Investor. What happens? The "oops" moment we talked about before which is while the USD gains ground against the majors i.e. EURUSD falling from 1.52 to 1.42 in a couple of weeks, the JPY gains ground testing 105.50 as these "so-called" carry trades are being unwound as a matter of liquidity need, rebalancing, and reinterpreting risk on their global books.
While this would be a perfectly nice explanation for the rise in JYP versus the USD the past week, it doesn't take into account the complexity of structured FX trades and the daily global flows that define both bank balance sheets for short-term loans and the larger world of longer-term investment flows. So, while it seems like we have found the elusive unwinding of the carry trade as the press headlines have us believe, much like the recent discovery of Bigfoot (only to learn it was a man clad in a rubber suit), perhaps in short order, the headlines will reflect that the carry trade unwinds might be hiding in that same rubber suit, too.
— Raja Ramachandran, Senior FX Advisor, Silicon Valley Bank's Global Financial Services
|
 |
Do you enjoy the ISO each week? Share it with colleagues or peers. Invite them to sign up using the link below.
|
|
 |
|
September 8, 2008
The Trouble with Senators (Redux)
Known as the world's greatest deliberative body, it often seems as though the Senate's lengthy debates are gumming up the workings of government. The unlimited speaking time and the cloture rule give every senator the power to stop the process. There are many instances in our history when one lonely senator courageously held out for a view that ultimately, with clarity of history, came to be the true and just course of action. This was done by design. The framers of our Constitution expected the Senate to mitigate the emotional and topical excesses that would likely flood through the House from time to time. The Senate was to be the calm, thoughtful, and methodical voice of reason. And, mostly, it has been a good thing.
The artful nuances of parliamentary procedure that define how they practice their craft are lost on most of us. Over the years, there are thousands of votes. Lofty goals are distilled into petty compromises. They pass "omnibus" bills with thousands of pages that no one member has read in their entirely. Thus, one senator's key piece of legislation may be combined with other laws he or she finds objectionable, linking that senator forever to those bad ideas. It is decision by committee where no one is truly responsible, and no one is ultimately accountable. This is how John Kerry came to make the famous statement — "I actually voted for the $87 billion before I voted against it" — expecting us to understand. We did not understand. The straight "up or down" vote on one simple clear proposal is a rarity.
War is perhaps the most consistent exception. Even there, the entire Vietnam War episode teetered legally on the thin language of the Gulf of Tonkin Resolution, which passed after seven hours of debate: 416-0 in the House and 88-2 in the Senate. Less than three years later when New York Senator Robert F. Kennedy rose on the Senate floor to criticize the conduct of the war, he stated, "I can testify that if fault is to be found or responsibility assessed, there is enough to go around for all -including myself." Compare that to the embarrassing squirming, bobbing, and weaving that we observe by many members today.
The one thing senators don't do is decide and execute. The sometimes goofy and outrageous statements issued from the steps of the Capitol may be good sound bites or grist for the blogosphere, but, ultimately, they become irrelevant as they are washed away with the next news cycle. Deciding and executing is left to the executive branch. This fact became obvious when Bob Dole was nominated for president. Although he was majority leader in the Senate and had authored some significant pieces of legislation, his time in the Senate never afforded him any executive experience. Executive experience is so prized by the electorate even governors of small states, like Jimmy Carter and Bill Clinton, were able to defeat incumbent presidents.
In an executive position, every utterance matters. As we have seen in the corporate corruption scandals in the U.S., the "shadow of the leader" influences every action and behavior far beyond the narrow scope of direct reports. So words and positions must be chosen carefully. Once launched by a president these words are very difficult to recall. Remember Nixon's, "Those statements are no longer operative"? As Representative Barney Frank of Massachusetts put it so succinctly in August 2004, "You can be a dysfunctional member of Congress, but not a dysfunctional governor. In Congress, there are 434 other people. You can't put a governorship on autopilot."
The last time a senator was elected president was in 1960 when John F. Kennedy, the junior senator from Massachusetts, and Lyndon Johnson, the majority leader of the Senate, were selected to run the country. In 2008, it is a certainty that we will have an ex-senator as the next president. The first version of this commentary appeared in November 2004, just after the election. It concluded with this line, "Given the fact that it has been 44 years since a sitting Senator was elected president, we humbly suggest that the parties focus on governors for '08." Oh, well.
Fannie and Freddie R.I.P.
At this writing, the Treasury announced a new regulator called the Federal Housing Finance Agency (FHFA) that has placed Fannie Mae and Freddie Mac into conservatorship. Jim Lockhart will head up the new agency. Once the two are stabilized, they will be reduced in size 10 percent per year beginning in 2010. By nationalizing these entities, the government is finally acknowledging the mistake of allowing them to grow out of control, distorting the mortgage markets in ways no one anticipated. These two entities were the origin of virtually all of the flawed lending practices behind the current crisis. The first subprime loans were made as a component of low-income housing mortgage targets established by Congress as part of their "oversight." Importantly, the corrupt revolving door between Fannie and Freddie and Congress will be shut. All lobbying activities will cease. The Treasury will guarantee a positive net worth via a senior preferred stock issuance facility and common and preferred dividends will be eliminated. This is, without question, the largest bailout in history. It is a somber lesson of what results when government ignores market forces and the Congress decides to pass new laws of economics.
Working harder for the same pay? Well, you're not alone. Final non-farm productivity surged to 4.3 percent in Q2. This is well above the 20 year average of 2.2 percent. The big picture seems to be employers cutting staff in expectation of a downturn (which has yet to appear if you believe the latest GDP numbers). More than 600,000 jobs have vanished since January, and, with the business activity still growing, those left behind after the layoffs are necessarily more productive. To put this all in perspective, 600,000 jobs is much less than one-half percent of the total labor force of 155 million. Still 9.4 million unemployed is bad news that will limit any early recovery for the struggling consumer sector.
Expectations for a Fed rate increase were pushed aside with the weak employment numbers. Yields fell 10 to 17 basis points across the curve with the 2-year closing up 8/32nds to yield 2.302 percent.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
|
|
|
|
|
|
|
|
Print Version 
