Thursday, November 12, 2009

The US Dollar Carry Trade Explained

The US Dollar Carry Trade has now broken through to mainstream consciousness. This blog, and many others of course, have been talking about this for years. Formerly disparate markets have slowly been converging for the past 10 years. The reason behind this is, quite naturally, unbacked credit expansion.

When there is no or dubious collateral behind a loan, it is only natural that the borrower will seek to speculate recklessly. The consequence of default is not the loss of anything tangible to them, only a poor credit record for a few years. And the rewards are huge if the speculation pans out. As this mentality among borrowers became entrenched, it had the effect of driving all asset classes that were typical recipients of this easy money together. Stocks, bonds, commodities, real estate, art, etc.

The source of this unbacked lending is difficult to pin down. We know that Japan was very active in pursuing credit expansionary policies in order to drive down their currency and support their export market. They lent to foreigners, and foreigners exchanged their Yen for other currencies and bought assets elsewhere. Japanese investors also took to investing abroad and gaining not only on asset appreciation, but on the depreciation in the Yen. This, known as the "Japanese Carry Trade" unwound spectacularly in 07-08. The Yen rose over 40% in 18 months, while the asset markets they were speculating in dropped by at least as much. Most who speculated in this trade likely lost 70% of their capital - all of it if they used any leverage.

Why was Japan the obvious choice for this? Because their interest rates were at near zero for years and there was no indication that they would be raised any time soon. Sound familiar?

It should, because that is the exact perception in the US. And that perception is probably correct. Benchmark rates will not be going anywhere soon. And now that the Fed has involved itself in many other markets (agency paper, money market funds, commercial paper, etc) there will be many moves to unwind these programs prior to raising interest rates. So there is no risk to this trade, right? We know better. So does everyone else. Everyone thinks, however, like the Japanese housewives playing in the forex markets, that they will be able to get out first once it begins to unwind. Simple mathematics tells us it is impossible. Like how 90% of drivers rate themselves as "above average."

In the minds of most, this doesn't matter. All that is important to today's ultra-short term minded investor is "how long will it last" and "how much money can I make?"

Often, once a trend has become common public knowledge, it is already over. This is the logic behind the magazine cover contrary indicator. Sometimes, however, the trend needs to become manic prior to exhaustion. In my opinion, we have already reached this point. Most others see the potential for it to last longer and run deeper. I suppose they could be right. Thinking back to early 2007, it looked fairly apparent that the Shanghai market was going to put in a top and was getting ahead of itself. It went on to double itself from those levels. It then lost 73% - halving those initial 2007 levels. Bubble callers were vindicated in the end but likely lost in three ways: shorting too early, missing a huge run-up, and being too shy at the real top.

There is a fine line between early and wrong. It is the same line between profit and loss. The flipside is that markets have an uncanny way of convincing you you're early, right before they turn around. I call this the path of maximum frustration.

The US Dollar Carry Trade is a bubble - just like all the others. It will unravel. I'm doing my best to hedge in the case of being too early in order to ensure I can participate in the unraveling process, which promises to be a doozy.

I look forward to the day when investing is again more about increasing productivity, wealth, prosperity, and less a game of Jenga. But when life gives you oranges...

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dacian said...


"Sometimes, however, the trend needs to become manic prior to exhaustion. In my opinion, we have already reached this point."

What point we reached? We need to wait for the trend to become maniac or it's already there (hence done)?


Jon said...

Great post. I think you have previously noted the lunacy of ignoring asset price inflation (esp. housing) as part of CPI or headline inflation figures. It strikes me that if this distortion was addressed, and the media widely reported figures that truly reflected the cost of living, it would be politically difficult to maintain artificially low interest rates and thus inflate bubbles to the same extent.

Anonymous said...

Hi Matt,

So how are you preparing for the soon-to-bust bubble? Any investment advice? Is the Japanese debt bubble going to pop before the US$ carry trade bubble. Which one pops first might influence investment/hedge choices.


mike.montchalin said...

Maybe I am too defensive?

I am still thinking of Latin America as a purely defensive move; specifically Peru, Columbia, Uruguay and Paraguay

Matt Stiles said...


Yes, the "dollar doom" trade becoming manic. I think it is sufficiently ingrained in the collective conscience of investors. It seems that even joe sixpack "knows" that the US dollar is headed toward zero.

scott, mike,

I'm long leap puts in the S&P. As a hedge I'm long puts in the Japanese Yen and the long bond (both of which I think could work out regardless of market direction). I might take some more risk in emerging markets if a selloff doesn't soon materialize and I'm wrong about the whole collective conscience thing reaching a peak.

Roger J said...

The carry trade play is Mr. Practical of Minyanville's favorite, except that he's standing on the other side of the trade. He gained lots of money by moving to Japan in 2007. And he's now back in the USA. Let's see how well he does this time. I wouldn't want to fight a hot-hand.

Anonymous said...

Meanwhile, over and over I see articles on WSJ, FT, etc. 'debunking' the USD carry-trade. Using shoddy reasoning, but still.

I can also remember the claims that that there was no housing bubble and that $100+ oil was just the start....

Anonymous said...

A well timed article.

I think you mean 'mainstream consciousness', not 'mainstream conscience'.

Matt Stiles said...


I haven't seen any of those "debunking" articles - I don't read either of those rags. Any links?


Indeed, you are correct. Poor word usage. Learn something new every day!

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