Felix Salmon on the dollar carry-trade

Here is a nice comment on Roubini's "mother of all carry-trades" claim.

No need to say how much I agree with this. I was the first to point out how unnatural this carry-trade situation looks like.

Here is my comment on Felix Salmon's post:

There is something unnatural to borrow from a country that is a net borrower itself. This kind of financial flow will have to be reversed sometime in the future. Where you may have had gradual build up of short dollar positions, once the trend is reversed, even by a small amount, the dynamics of the system can change significantly. That is, nobody likes to be the last person out, so the pure momentum of people rushing for the exit, first for locking their profits and later for cutting their losses, will lead to spectacular dollar comeback.

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This is just a small observation. As the dollar is loosing value three different currency pairs are gradually moving to parity---the AUDUSD, USDCAD, and USDCHF.

The closest one is the Frank. It closed at 1.008 this week, just shy from the parity mark.

Then there are the commodity currencies, that have been riding the recovery wave as a couple of easy going surfer dudes. The Aussie and the loonie are trading respectively at 1/0.922 and and 1.052 to the greenback, nearing this point where all the dollars in the world will come together as equal and throw a big party to celebrate their colonial heritage.

It seems that these three 1s will be reached at the same time, so when this happens, close your eyes and make a wish. What happens next, however, is anybody's guess. All this talk of how the cheap dollar is hurting the economies of all other countries but the US whispers of a big massive coordinated intervention. It will be a game of chicken, and is there a bigger chicken then the ECB?

And to avoid making my case for ECB intervention, I am just posting a link to an FT article that does it for me.

There are two questions that I am looking forward to be answered this week and both of them are related to the US dollar.

1. Will the dollar keep losing ground?
2. What will the FOMC statement say?

Since the beginning of September the dollar's decline has been as smooth as a bunny slope ski ride. At the end of last week, however, it seemed that this ride is coming to an end. After storming the 1.475 level the dollar kept flirting with the 1.47 line for the whole Friday. It is quite possible that the current trend is out of steam, at least until the FOMC comes with their view of what comes next. There are two outcomes that are almost sure to emerge from the Fed meeting. First, the interest rate will remain unchanged since inflation is obviously too tame to cause any policy change. Second, it looks like the quantitative easing has run its course and the Fed should be back to business as usual. The FOMC statement should answer, however, the important question of what are the inflation expectations moving forward, and how the Fed plans to answer any changes in the current status in the future. Trichet already had his say on the topic:

Available indicators of inflation expectations over the medium to longer term remain firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term. The outcome of the monetary analysis confirms the assessment of low inflationary pressure over the medium term, as money and credit expansion continues to decelerate.

Now, its time to see what is the US view on the subject, but most probably it will be on the same note. In this line, I expect the EURUSD to remain in the 1.465-1.475 range until Wednesday, when the Fed position becomes clear. Bearing any unexpected developments, the dollar then may continue to lose value, where my personal opinion is that it can cross 1.485 to the end of the week.

The dollar as a carry-trade currency

There are a lot of speculations lately that the dollar is increasingly becoming the top choice for a carry-trade currency. Financial Times writes:

Analysts say negligible US interest rates, its quantitative easing measures and little sign that the country is set to withdraw from its ultra-loose monetary policy anytime soon leaves it in a similar position to Japan at the start of the decade.

Or in other words, the investors find it advantageous to borrow dollars and invest them in high-yield currencies, in the same way they were doing with the Yen until the carry trade burst in the end of 2007. The FT article proceeds at giving equivocal evidence that the current decline of the dollar is caused by the dusting-off of the old vanilla borrow-exchange-deposit strategy, that was quite profitable before the current great recession. Their list is:

1. The dollar LIBOR is currently smaller than the Yens.
   
2. The dollar seems to be losing uniformly against all major traded currencies.
   

I have to agree. To these evidences, I can add the TIC long-term purchases which turned out well below estimates ($15.3B actual vs $65.0B expected). However, my opinion is that the dollar makes a pretty crappy carry-trade funding currency and these are the reasons.

1. The US has enormous current account deficit.
Economics 101 is that a country with a current account deficit is a net borrower. That is it imports more than it exports, and therefore needs somebody (read China) to finance this imbalance. The carry-trade will exacerbate this, i.e. people will be less likely to hold US debt, since they will want to get US loans. In the case of yen as a carry-trade funding currency, this wasn't an issue, since Japan is a net lender, and the carry trade was beneficial for its economy. Joe gives one dollar to Toyota, Toyota turns it into Yens, then Patric borrows it from Toyota turns it into Iceland crones, puts it in the bank and collects interest. Of course, this didn't turn out good for everybody.

2. Inflation is lurking around the corner.
You don't need much for inflation to catch you with your pants down. A sudden spike in commodity prices will be promptly distributed down the chain to both consumers and manufacturers, and bring high interest rates without having stable economic rebound. We've seen that the $150 oil is possible, and there are a lot of scenarios under which it can happen again (think about Iran.) If/when this happens the carry-trade game can easily turn into a game of musical chairs.

To summarize, I am suspicious about the current depreciation of the dollar. There may be a point in the future, that the dollar wins back in a matter of days what the euro has won in the last few months. I'll be looking for the signs ready to catch this fast train back south.