Sunday, 20 September 2009

US dollar carry trade starting to look shaky

For those USD bulls out there?

Gertrude Chavez-Dreyfuss and Wanfeng Zhou
NEW YORK, Sept 17 (Reuters)

A risky strategy using the US dollar to finance bets in higher-yielding currencies such as the Australian dollar could unwind quickly if this year's rally in global stocks fades.

Record low US interest rates, a commitment by the Federal Reserve to refrain from tightening monetary policy for a long period of time, along with improving global economic prospects have prompted investors to sell the US dollar in carry trades the last few weeks.

Carry trades involve transactions in which investors borrow in a low interest currency and use the funds to invest in higher-yielding assets in other countries. These strategies thrive in an environment of low volatility and economic expansion.

A nearly 70 percent surge in the broader MSCI world stock index from its low in March this year has also enhanced the carry trade's appeal. The Australian dollar , on the other hand, a carry trade beneficiary which moves in tandem with stocks, has risen 23 percent versus the greenback.

But dollar carry trades could have a shorter lifespan than most people think. A sustained pullback in stocks could dim the carry trade's attraction." Everybody's piling into equities and selling the dollar in carry trades and the main driver is not recovering earnings, it's the fact that prices keep going up," said Andrew Wilkinson, senior market analyst at Interactive Brokers in Greenwich, Connecticut.

Not too long ago, the yen and Swiss franc, with their near-zero interest rates, were the preferred funding currencies in carry trades. But a couple of weeks ago, the cost of benchmark three-month interbank dollar funds fell below those of the yen and Swiss franc. "It wouldn't surprise me that in the middle of one or two earnings cycles, people would reevaluate global prospects for growth," Wilkinson said. "So it makes me wonder how fast you can short the dollar without running the risk of a fast snapback in your face."

In many regions, less bleak economic data has morphed into upbeat reports and it seems the rebound in stocks and the dollar's sell-off has taken on a self-reinforcing quality despite persistent worries about rough times in credit and a weak lending trend by banks.

Analysts also say the interest-rate environment is too uncertain for a dollar-carry trade to survive for too long, and they believe the yen carry trade will re-emerge because of Japan's wide output gap. The output gap refers to the difference between an economy's current output and its maximum potential output. A wider gap reflects declining wages and lower inflation, and it impedes a central bank's ability to raise interest rates.

Japan's rates were low for years, which made such trades easier, but analysts do not foresee such a repeat in the U.S. "Japan has a much larger output gap than the U.S.," said Paresh Upadhyaya, portfolio manager, at Putnam Investments in Boston. "I don't believe U.S. rates will remain low for a long enough period of time for the dollar to cement its status on a multi-year basis as a funding currency."

Analysts give U.S. dollar carry trades a shelf life of six months to one year -- nowhere near the yen's lifespan of almost a decade as a carry trade vehicle. Samarjit Shankar, managing director of global FX strategy at BNY Mellon in Boston, said much uncertainty remains about the outlook for the rate-tightening cycle once the global recovery takes hold."

Interest rates will be changing quite a bit going forward. It's a much more fluid situation in terms of the attraction of lower rate currency for funding the carry trade."

Technical indicators are also starting to suggest that dollar selling is getting overextended.In the options market, traders say over a three-month horizon, euro puts, or bets the euro will fall, are getting more expensive than calls, referring to options which reflect expectations the currency will rise. This shows that as the euro rises, more and more investors are buying downside protection in case it falls.

Meanwhile, according to Barclays Capital's implied probability distribution data, which is useful in pricing call and put options, the market has also attached a high probability that the dollar will rally against the yen. Barclays fair value estimates predicted a decline of 0.3 percent in the latest week, but the actual fall in spot was 2.6 percent, making the greenback 6.2 percent undervalued. That's the largest undervaluation in the last 12 months.

These numbers suggest a turn higher in dollar/yen is imminent as positioning has become overstretched.This was also evident in Barclays' implied distribution data. The probability of dollar/yen trading above 94.57 yen was about 25 percent in the latest week compared with a 22.8 percent chance the pair will move below 86.4 yen.

1 comment:

paul scott said...

An interesting dissertation from you dude,
What I mean is who the fuck is
Gertrude Chavez-Dreyfuss and Wanfeng Zhousuggesting,
jeez dude, $NZ