Would you like a carry trade with that?
Posted on 20 November 2009
The ‘carry trade’ is in the paparazzi’s sights. Have a look how it is faring on Google Trends:
It’s latest incarnation is via the USD. And as David Rosenberg points out – it looks like the world’s reserve currency is being used to fund just about every asset beyond cash on the risk spectrum.
The U.S. dollar has become a huge ‘carry trade’ vehicle for all risky assets. Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.
(Source: Gluskin Shelf)
My sense is that with it’s rise into public awareness, we are heading into the final throes of USD weakness. For example, when someone like Felix Salmon writing for Reuters does a survey of “How US investors can play the carry trade” that’s got to be a flag. And when phrases like ‘the gimme trade of the century’ are used (Annaly via TPC) in the same breath as describing it’s dynamics – the risk that complacency has set in is pretty darn high.
Think about it – the (currency version of the) carry trade says that you can borrow cheap in USD, sell those freshly minted dollars and buy into a higher yielding currency. The assumption is that the USD will continue to fall – so that in addition to the yield pick-up, you make a capital gain when you buy your USD back. So what happens if that higher yielding currency appreciates before you make that purchase? The carry is still there – it’s a function of interest rate differentials – just that you are going to pay more for that other currency now. Clearly, there is some point where that higher yielding currency becomes “overvalued” relative to the funding currency regardless of the carry.
Now this trade has a long history. The JPY and CHF have been favourites over the last 20 years. We have had Belgian dentists and Japanese housewives. And as a disgruntled group of Australian farmers will tell you – it can really hurt when this trade goes against you. (Australian banks promoted swiss franc loans to the grass chewing mob on the basis of the low CHF interest rates – it ended in tears and lawsuits.)
Here is Google trends going as far back as it will take us:
The point is the ‘carry trade’ is an outright bet on a weakening USD (or at least one that does not appreciate by much). If the cover of the Economist covers it, we will have confirmation that the bottom is in.
15 responses to Would you like a carry trade with that?
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Good post. Sound reasoning.
One more note: carry trades tend to blow up shortly after the implied volatility of options used to hedge such trades rise to levels making hedging costly.
Also, look at the ticker DBV — that *is* a carry trade fund. When volatility kicks up, it falls.
David,
Thanks for your thoughts. I’m not across how USD volatility has been trading of late. I can see your reasoning though – if volatility is being bid up, particularly if the smile is getting skewed against the grain of the carry trade, it’s a pretty clear indicator that things ain’t right.
Regards
Good post. Sound reasoning.
One more note: carry trades tend to blow up shortly after the implied volatility of options used to hedge such trades rise to levels making hedging costly.
Also, look at the ticker DBV — that *is* a carry trade fund. When volatility kicks up, it falls.
David,
Thanks for your thoughts. I’m not across how USD volatility has been trading of late. I can see your reasoning though – if volatility is being bid up, particularly if the smile is getting skewed against the grain of the carry trade, it’s a pretty clear indicator that things ain’t right.
Regards
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