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...
Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.