March 6, 2007

What Good is the Carry Trade?

Much of the blame for last week's shellacking of financial markets around the world has been attributed to the "unwinding" of the Yen "carry trade". That is, when hedge funds and other financial institutions closed out investment positions funded by money borrowed at low rates of interest from Japan.

After the Bank of Japan raised interest rates a few weeks back, the Yen strengthened and the higher borrowing cost combined with a narrowing exchange rate differential began to eat into investors' gains.

Spurred by a recession warning from Alan Greenspan and the plunge in the Shanghai Composite index last Tuesday, carry trade profits were promptly taken, resulting in the sale of stocks, commodities, currencies, probably a few paintings, and who knows what else.

The after-hours plunge of over $20 in the price of gold on the New York Access market last Tuesday is being attributed, at least in part, to the sale of more than six tonnes of gold bullion by the streetTRACKS Gold ETF (AMEX: GLD), a trading vehicle that has apparently become quite popular with hedge funds and other speculators.

The price of the metal had fallen only a dollar or two when the COMEX closed at 1:30 PM, but as of 4:15 PM, the gold ETF had lightened its load by a couple hundred thousand ounces. Clearly, there were few buyers for the supply being liquidated.

Similarly, high-yielding currencies in countries such as New Zealand and South Africa plunged as foreign currency positions, funded by the carry trade, were liquidated.

For the rest of the week, the rout was on for equity markets around the world, margin calls were made, and forced selling ensued.

The highly leveraged bets of hedge funds using cheap money denominated in the lowest yielding currencies once again wreaked havoc with financial markets.

When Rates were Low in the U.S.

Not more than a few years ago, in the aftermath of the bursting of the U.S. stock market bubble when the short-term interest rate was only one percent, the U.S. Dollar was the preferred funding source for the carry trade.

There was great trepidation in mid-2004 when former Fed Chairman Alan Greenspan, a staunch backer of hedge funds over the years, began his "baby step" interest rate normalization campaign that eventually saw short-term rates climb 425 basis points .

Though many expected some sort of disaster, there were few problems. However, interest rates rising at a snail's pace over a two year period emboldened borrowers around the world and at the top of the list of confident punters were buyers of real estate in the U.S.

Many of these loans are now going bad.

If not for the carry trade would interest rates in the U.S. have been raised at a faster pace avoiding some of the most egregious practices of the last two years in the U.S. housing market?

No one will ever know, but all of this prompts the question, "What Good is the Carry Trade?"

In comments yesterday in Greenwich, Connecticut, Assistant Treasury Secretary Anthony Ryan noted that, "few groups are more adept at identifying opportunities and moving capital around the world than those managing hedge funds."

But do they have to do it with money borrowed from countries with weak economies?

This distorts the entire exchange rate picture and only benefits hedge fund managers and their investors. There is no discernible improvement in the "allocation of capital" - it's just "asset shuffling".

More Bubbles

It seems that all the carry trade really accomplishes is a further "bubbleization" of the world economy. Some hedge funds will reap huge profits and others will fail disastrously. Some rich investors will get a little richer and some will lose out. Some pension funds will have huge surpluses and some will have to resort to plan "B" to fund retirements.

Meanwhile, emerging economies struggle to survive the torrent of carry trade money and markets become more volatile.

There is an enduring idea that if the "the market" sets the price of currencies, equities, commodities, and other assets, then this is somehow better. The market knows best. But if "the market" is dominated by hedge funds with easy access to cheap money, this can be more destabilizing than beneficial.

Now Hank Paulson is over in Asia trying to reassure everyone that things are going to be OK - that another meltdown is not in store.

Speculators have always played an important role in financial markets, but why must they be provided with such easy access to cheap money?

What good is the carry trade?