Carry Trade Still Popular, but Doubt is Growing

It’s safe to say that the inverse correlation observed 

between the Dollar (and also the Yen)

and global equities is largely a product of the carry

trade. “The U.S. stock market bottomed and the U.S. Dollar 

Index peaked almost simultaneously in March. WhileU.S. stocks

are up more than 50% in that time, the Dollar Index (which measures 

the greenback’s value against the euro, the yen, the British pound, the

Canadian dollar, the Swedish kroner and the Swiss franc) is down nearly

12%,” observed one analyst.

On one level, this represents a return to 2008, prior to the explosion

of the credit crisis, when carry trading was THE dominant theme in

forex markets. However,there is one important difference. While 

the Dollar and Yen were the funding currencies then and now 

(due to their low interest rates), there has been a slight shift in the

currencies selected for the opposing/long end of the trade.

Traditionally, the most popular long currencies were those
 of industrialized countries, rich in commodities and backed
by high interest rates and often rich in commodities. To be
sure, these currencies have shined in recent months, certainly
 due in part to speculative (carry) trading.
“Strategists at Wells Fargo Bank in New York
‘believe that the gains in the dollar-bloc currencies
 (Australia, New Zealand, Canada) have run ahead
 of the gains in commodity prices.’ ” The Bank of Canada
 also noticed that “At the time of its last statement,
oil prices were about $75 a barrel, but now they are
 in the $60-to-$65 range. That suggests the currency’s
appreciation has outpaced the demand for its commodity exports.”

But the run-ups in the Kiwi, Aussie, and Loonie have been
 overshadowed by even more rapid appreciation in
 emerging market currencies. This shift is largely a product
of changes in interest rate differentials, which are now
 gapingly large between developed countries and developing
countries. Compare the 2.75%+ spread between the US and
 Australia, with the 8.5% spread between the US and Brazil or
12.75% between the US and Russia. For investors once again
becoming complacent about risk, the choice is a no-brainer.

Still, some analysts are nervous about this change in dynamic:
 “While the new carry trade may be less leveraged, it’s an
inherently riskier bet. As such, it’s more vulnerable to the kind
 of swift unraveling of risk appetite observed across all nations
and sectors in 2008, but which occurs with far more frequency in
 emerging markets.” Meanwhile, emerging market stocks have
behaved volatilely over the last few weeks (with Chinese stocks
even entering bear market territory), and some investors are
concerned that they may be temporarily peaking. There are also
 signs that bubbles may be forming in carry trade currencies,
 with bullish sentiment at high levels. Accordingly, one strategist
 suggests waiting out a 5% pullback in the Australian dollar, and
a 10% pullback in the New Zealand dollar before going back in.

There is also the outside possibility that the Fed will raise
 interest rates, which would crimp the viability of the US Dollar
as a funding currency.
Granted, it seems unlikely that the Fed will tighten within the
next six months, but investors with a longer time horizon could
begin to adjust their positions now, rather than wait until the 11th hour,
at which point everyone will be rushing for the exits.