Future bubbles Dollar carry trade

Concept of carry trade

The concept of carry trade has been taken from the arbitrage world where people looks for
the risk free opportunity to make money with investments, although involvement of risk is
not nullified in the carry trade however modus operandi of this is almost similar to arbitrage
operations.

Here's an example of a "U.S.dollar carry trade" a trader borrows 1,000 U.S.dollar from a
U.S bank, and then converts the funds into Indian National Rupee and buys a financial
assets of the equivalent amount in India in the form of bond ,stocks, debenture etc. Let's
assume that the investment in India pays 6.5% and the U.S. interest rate is set at 0.25%.
The trader stands to make a profit of 6.25% as long as the exchange rate between the
countries does not change. Many professional traders use this trade because the gains can
become very large when leverage is taken into consideration. If the trader in above example
uses a common leverage factor of 10:1, then they can stand to make a profit more than
62%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above,
if the U.S. dollar will fall in value relative to the INR, then the trader would run the risk of
losing money. Also, these transactions are usually done with a lot of leverage, so a small
movement in exchange rates can result in massive losses unless the position is hedged
appropriately.

Events that shaped the dollar carry trade

The easy money policy from the central bank’s around the Globe created ample liquidity in
the markets, especially near to zero interest rate policy that adopted by the U.S. Federal
reserve created huge outflow of dollar from the U.S. to emerging markets and this over
supply of Dollar resulted in the deprecation of dollar with respect to all major currency.
Emergence of carry trade has taken birth in the above events, in this trade people takes
money from the U.S. due to the negligible interest rate regime over there and parks those
money in the high return securities around the globe, due to this Global markets have
rallied "too much, too soon, too fast" in 2009,but a correction is inevitable once fed will
shed this policy, the rising inflation is the one of the important indicator which will force the
regulator in near future to rethink on easy money policy, although it will not happen right
away, as a cheap dollar will still encourage investors to seek higher-yielding assets for a few
more months, however time is short for the people who bets on liquidity driven asset.

Recovery of U.S. dollar which is traded at the year low is depend upon the rise in interest
rate which will led the repatriation of US dollar , but only in "six to twelve months from now,
not any time soon."A correction might occur, but the risk of a correction is more in the
medium term than in the short term, but the time when the correction will come it will
sharp and painful for the equity markets around the globe because the equity rally has
fuelled by U.S.dollar.

The economist repeating their view that the U.S. economic recovery will be anemic, subpar
and U-shaped, which should decipher into worse-than-expected corporate earnings and
macroeconomic indicators, eventually forcing asset prices down.

Such a correction will be delayed, due to support of the regulatory provisions of prolonged
period of low interest rates, easy finances, bailouts and fiscal stimulus packages.

Many analysts are of the opinion that the real economy will surprise on the downside,
especially when the stimulus oxygen fizzled out, but on the other side we will have the
effects of policies, especially monetary and liquidity, that keep asset prices levitating.

Money wheel around the globe

Loose monetary policies around the world has resulted in continuous dollar inflows into
developing economies and emerging markets are likely to grow faster than developed world
for several years from now onwards, here Asia under the leadership of twin engine China
and India going to outperform in this growth run due to their consumption base .

The challenge for emerging market countries like Brazil and India will be to implement
effective policies to curb excessive capital inflows that have led to appreciation in their
currencies; Brazil has imposed Tobin tax of 2% to curb the foreign inflows. The reason is
obvious, because the rider of the inflow is greed of return which is not going to last forever,
sooner or later it will unwind their trade and unwinding of trade will be painful for the
emerging markets. The depreciating dollar is creating the risk for the exporter. The solution
is probably along the lines of capital controls but capital control is the toughest step for the
capital deficit emerging markets. Here money is chasing their growth with objective to get
more return in shortest time and this objective is the evil of stable financial market so it is
about to create volatility in the markets and no nation wants volatile financial market. This
is the prime reason behind the imposition of tax on inflow by Brazil.

Impacts of carry trade

The beginning of carrying trade has infused the liquidity in the financial and commodity
market around the globe. Chase of U.S.dollar pushed the Gold, Crude at 52 week high in
2009 and same effect has observed in equities around the globe Brazilian equity index
bovespa has outperformed the world with hefty gain of 145% by the time this article were
written on strong dollar inflow to the capital market. Dollar index came down sharply to
their year high 89.62 on 4th march to the year low 74.17 on 26th November and take
pullback from there. In the next six month when economy will come on growth path then
inflation will be the primary agenda for the fed and they will increase the interest to suck
the excess liquidity from the market. Rise in interest rate will trigger the unwinding of dollar
carry trade. The unwinding of trade will create volatility in the stock market around the
world it can led to another stock market carnage in the emerging market because significant
amount of fund by FII and hedge fund has been pumped into the equity markets during
their up move.

Fig: Dollar index for the year 2009.

Unwinding the trade will create revisal in dollar index and dollar will appreciate significant from the
current level which will lead to unusual depreciation of the local currency. The excess volatility will be
disastrous for the exporters. Because their profit margin will be impacted and it will create unnecessary
pressure in the balance sheet of the company so further slowdown cannot be ruled out in export based
sector in the emerging markets like India.

Pankaj Kumar
21-dec-2009