Unwinding the Mother of All Carry Trades?

Over the weekend, Mike Whitney wrote an interesting comment for Counterpunch, Why a Stronger Dollar will Lead to Deflation, Recession and Crisis:

“There are no nations…. no peoples…. no Russians.. no Arabs…no third worlds…no West. There is only one holistic system of systems, one vast and immane, interwoven, interacting, multi-variate, multi-national dominion of dollars. Petro-dollars, electro-dollars, multi-dollars, reichmarks, rins, rubles, pounds, and shekels. It is the international system of currency which determines the totality of life on this planet. That is the natural order of things today.”

– Arthur Jensen’s speech from Network, a 1976 American satirical film written by Paddy Chayefsky and directed by Sidney Lumet

The crisis that began seven years ago with easy lending and subprime mortgages, has entered its final phase, a currency war between the world’s leading economies each employing the same accommodative monetary policies that have intensified market volatility, increased deflationary pressures, and set the stage for another tumultuous crack-up. The rising dollar, which has soared to a twelve year high against the euro, has sent US stock indices plunging as investors expect leaner corporate earnings, tighter credit, and weaker exports in the year ahead. The stronger buck is also wreaking havoc on emerging markets that are on the hook for $5.7 trillion in dollar-backed liabilities. While most of this debt is held by the private sector in the form of corporate bonds, the stronger dollar means that debt servicing will increase, defaults will spike, and capital flight will accelerate. Author’s Michele Brand and Remy Herrera summed it up in a recent article on Counterpunch titled “Dollar Imperialism, 2015 edition”. Here’s an excerpt from the article:

“There is the risk for a sell-off in emerging market bonds, leading to conditions like in 1997. The multitrillion dollar carry trade may be on the verge of unwinding, meaning capital fleeing the periphery and rushing back to the US. Vast amounts of capital are already leaving some of these countries, and the secondary market for emerging bonds is beginning to dry up. A rise in US interest rates would only put oil on the fire.

The World Bank warned in January against a “disorderly unwinding of financial vulnerabilities.” According to the Financial Times on February 6, there is a “swelling torrent of ‘hot money’ cascad[ing] out of China.” Guan Tao, a senior Chinese official, said that $20 billion left China in December alone and that China’s financial condition “looks more and more like the Asian financial crisis” of the 1990s, and that we can “sense the atmosphere of the Asian financial crisis is getting closer and closer to us.” The anticipated rise of US interest rates this year, even by a quarter point as the Fed is hinting at, would exacerbate this trend and hit the BRICS and other developing countries with an even more violent blow, making their debt servicing even more expensive.” (Dollar Imperialism, 2015 Edition” Michele Brand and Remy Herrera, CounterPunch)

The soaring dollar has already put the dominoes in motion as capital flees the perimeter to return to risk-free assets in the US. At present, rates on the benchmark 10-year Treasury are still just slightly above 2 percent, but that will change when US investment banks and other institutional speculators– who loaded up on EU government debt before the ECB announced the launching of QE–move their money back into US government bonds. That flush of recycled cash will pound long-term yields into the ground like a tent-peg. At the same time, the Fed will continue to “jawbone” a rate increase to lure more capital to US stock markets and to inflict maximum damage on the emerging markets. The Fed’s foreign wealth-stripping strategy is the financial equivalent of a US military intervention, the only difference is that the buildings are left standing. Here’s an except from a Tuesday piece by CNBC:

“Emerging market currencies were hit hard on Tuesday, while the euro fell to a 12-year low versus the U.S. dollar, on rising expectations for a U.S. interest rate rise this year. The South African rand fell as much as 1.5 percent to a 13-year low at around 12.2700 per dollar, while the Turkish lira traded within sight of last Friday’s record low. The Brazilian real fell over one percent to its lowest level in over a decade. It was last trading at about 3.1547 to the dollar…

The volatility in currency markets comes almost two years after talk of unwinding U.S. monetary stimulus sent global markets reeling, with some emerging market currencies bearing the brunt of the sell-off…

Emerging market (EM) currencies are off across the board, as markets focus back on those stronger U.S. numbers from last week, prospects for early Fed tightening, and underlying problems in EM,” Timothy Ash, head of EM (ex-Africa) research at Standard Bank, wrote in a note.

“In this environment countries don’t need to give investors any excuse to sell – especially still higher rolling credits like Turkey.” (Currency turmoil as US rate-hike jitters bite, CNBC)

Once again, the Fed’s easy money policies have touched off a financial cyclone that has reversed capital flows and put foreign markets in a downward death spiral. (The crash in the EMs is likely to be the financial calamity of the year.) If Fed chairman Janet Yellen raises rates in June, as many expect, the big money will flee the EMs leaving behind a trail of bankrupt industries, soaring inflation and decimated economies. The blowback from the catastrophe is bound to push global GDP into negative territory which will intensify the currency war as nation’s aggressively compete for a larger share of dwindling demand.

The crisis in the emerging markets is entirely the doing of the Federal Reserve whose gigantic liquidity injections have paved the way for another global recession followed by widespread rejection of the US unit in the form of “de-dollarization.” Three stock market crashes and global financial meltdown in the length of decade and a half has already convinced leaders in Russia, China, India, Brazil, Venezuela, Iran and elsewhere, that financial stability cannot be achieved under the present regime. The unilateral and oftentimes nonsensical policies of the Fed have merely exacerbated inequities, disrupted normal business activity, and curtailed growth. The only way to reduce the frequency of destabilizing crises is to jettison the dollar altogether and create a parallel reserve currency pegged to a basket of yuans, dollars, yen, rubles, sterling, euros and gold. Otherwise, the excruciating boom and bust cycle will persist at five to ten year intervals. Here’s more on the chaotic situation in the Emerging Markets:

“The stronger the US boom, the worse it will be for those countries on the wrong side of the dollar. [...] The US Federal Reserve has pulled the trigger. Emerging markets must now brace for their ordeal by fire. They have collectively borrowed $5.7 trillion, a currency they cannot print and do not control. This hard-currency debt has tripled in a decade, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. It is comparable in scale and ratio-terms to any of the biggest cross-border lending sprees of the past two centuries. Much of the debt was taken out at real interest rates of 1pc on the implicit assumption that the Fed would continue to flood the world with liquidity for years to come. The borrowers are ‘short dollars’, in trading parlance. They now face the margin call from Hell…. Stephen Jen, from SLJ Macro Partners said that ‘Emerging market currencies could melt down. There have been way too many cumulative capital flows into these markets in the past decade. Nothing they can do will stop potential outflows, as long as the US economy recovers. Will this trend lead to a 1997-1998-like crisis? I am starting to think that this is extremely probable for 2015.’” (Fed calls time on $5.7 trillion of emerging market dollar debt, Ambrose Evans Pritchard, Telegraph)

As the lone steward of the reserve currency, the Fed can boost global liquidity with a flip of the switch, thus, drowning foreign markets in cheap money that inevitably leads to recession, crises, and political unrest. The Fed was warned by Nobel Prize-winning economist, Joseph Stiglitz, that its loosy goosy-monetary policies, particularly QE, would have a ruinous effect on emerging markets. But Fed Chairman Ben Bernanke chose to shrug off Stiglitz’s advice and support a policy that has widened inequality to levels not seen since the Gilded Age while having no noticeable impact on employment , productivity or growth. For all practical purposes, QE has been a total flop.

On Thursday, stocks traded higher following a bleak retail sales report that showed unexpected weakness in consumer spending. The news pushed the dollar lower which triggered a 259 point rise on the Dow Jones. The “bad news is good news” reaction of investors confirms that today’s market is not driven by fundamentals or the health of the economy, but by the expectation of tighter or looser monetary policy. ZIRP (Zero interest rate policy) and the Yellen Put (the belief that the Fed will intervene if stocks dip too far.) have produced the longest sustained stock market rally in the post war era. Shockingly, the Fed has not raised rates in a full nine years due in large part to the atmosphere of crisis the Fed has perpetuated to justify the continuation of wealth-stripping policies which only benefit the Wall Street banks and the nation’s top earners, the notorious 1 percent.

The markets are bound to follow this convoluted pattern for the foreseeable future, dropping sharply on news of dollar strength and rebounding on dollar weakness. Bottom line: Seven years and $11 trillion in central bank bond purchases has increased financial instability to the point that any attempt to normalize rates threatens to vaporize emerging markets, send stocks crashing, and intensify deflationary pressures.

If that isn’t an argument for “ending the Fed”, then I don’t know what is.

There is a lot to cover in the article above which contains some excellent points but ends with the typical "end the Fed" rubbish that appeals to financial imbeciles who don't understand the important role of the Federal Reserve.

First, Whitney is right, the mighty greenback is wreaking havoc on emerging markets and the risks are being exacerbated by the dollar carry trade. To understand why, go back to read a Forbes article written last year by Bert Dohmen, founder of Dohmen Capital, titled "Carry Trade: The Multi-Trillion Dollar Hidden Market":

The dollar is soaring. The U.S. stock market is making new highs. U.S. T-bond yields are declining, causing T-bond prices to rise while all the experts say they are too overvalued. European government bonds actually yield less than U.S. Treasuries, which makes no sense because the U.S. bonds are considered much safer. Many analysts confess that they are mystified.

What is the driving force for these moves? The “carry trade.”

What is the carry trade? It’s the borrowing of a currency in a low interest rate country, converting it to a currency in a higher interest rate country and investing it in the highest rated bonds of that country. The big trading outfits do this with leverage of 100 or 300 to one. This causes important moves in the financial markets, made possible by the trillions of dollars of central bank money creation.

The monetary stimulus in Japan is aimed to produce a cheaper yen, and thus a stronger dollar. That causes the U.S. bond market to rise, bond yields to decline, commodity prices to plunge, and precious metals prices to decline. If you are in any of these investments, you must know what drives their prices.

Here is how the “yen carry trade,” a favorite currency for the trade, basically works now:

• Hedge funds and other very big traders borrow the yen at very, very low interest rates now approaching zero.
• The yen are converted to dollars, which are invested in U.S. Treasuries at a much higher yield than the interest cost for the borrowed yen. That creates a “positive carry” because of the differential in interest rates.
• The buying drives up U.S. bond prices. The traders accrue big profits, when done with high leverage, assuming the yen value doesn’t rise.
• Additional profits are made when a) The dollar rises vs. the yen as the BOJ intends, b) U.S. Treasuries rise in price (as is happening)
• Triple Profits: A leverage 100:1 means that a 1% rise in the value of the dollar vs. yen doubles the value of the equity investment. An additional profit is made if the U.S. T-bonds rise in price as they have done. Further profits are made from the positive carry, i.e. when the yield on the T-bonds is greater than the interest cost on the yen. That’s a “triple profit.”
• So far, so good. And that’s what is happening now. Some of the profits are probably reinvested in the stock market for diversification.

The emerging markets have benefited from this as well. The currencies of the lower-interest countries like Japan or the U.S. are borrowed and invested in the much higher-yielding bonds of emerging countries. The danger is that when one of these countries has trouble paying the interest on its debt, there is a huge unwinding of this trade, hundreds of billions of dollars flow out, and an emerging market crisis produces a world-wide market crash. That’s what happened in 1997 and 1998. The emerging markets carry trade is estimated to be at least $2 trillion in size. That’s huge.

The carry trade is great for the big trading outfits, but it doesn’t help the average person. And that is why there is such great income disparity. It’s just financial engineering.

However, there is possibly another, much more important element to these trends: Russia!

When Russia basically annexed the Crimea in March of this year, I proposed in our Wellington Letter that the U.S. could easily manipulate the oil price down to levels that would significantly damage Russia’s economy.

How do you get the international oil price down? Oil is denominated in dollars. If the central bank (the Fed), in collaboration with the large financial firms manipulate the U.S. dollar upward, it increases the cost of oil around the world. That reduces consumption, which reduces the oil price. Above I described how the carry trade increases the value of the dollar. Everything works together.

Oil revenues are the greatest source of foreign currency reserves for Russia. It needs these reserves to service its international debt. If these reserves dwindle, another Russian debt crisis and possible default similar to the late 1990’s could occur. The global markets would plunge, but Russia would be hurt the most. Perhaps that would cause Putin to retreat from his apparent plan to reassemble the old Soviet Union.

Conclusion: The carry trade causes a rising U.S. dollar, rising U.S. bond prices, rising U.S. stocks, and deflation in commodity prices. Of course, an unwinding of the carry trade will cause the opposite.

The soaring dollar and strong U.S. Treasury market confirm that the carry trade is alive and well. If and when the Bank of Japan hikes interest rates in order to combat rising inflation, the carry trade will unwind, perhaps ferociously. So, watch the BOJ.

The massive money creation of the major central banks and their “ZIRP” policy (zero interest rate policy) has created such huge financial speculation using other methods as well, making big speculators very rich. And that includes the large trading operations at the Wall Street firm, the biggest global banks, and hedge funds.

Keep the article above in mind in order to understand why the U.S. dollar and bond prices are surging, commodity prices plunging and emerging market debt and stocks are getting hammered. It's all part of a global, massive carry trade engineered by big banks and their big hedge fund clients which have leveraged this trade to the tilt.

And now that the euro is crashing and yields in the eurozone's core economies are at historic lows as the ECB moves ahead with its version of quantitative easing, investors are getting creative with the carry trade, selling euros to buy Indian and Indonesian debt:

Whipsawed by upheaval in the world’s foreign-exchange market, investors are ripping up the rule book on a popular trading strategy.

For years, traders big and small had used a tried, and usually true, way to make money: borrow cheaply in a country with low interest rates and a weak currency, typically Japan, and then invest in a country with higher rates such as Australia or South Africa.

But a wave of central-bank moves and shifts in regional economies in recent months have upended the strategy, known as the carry trade. The Australian dollar and South African rand are tumbling, while the Japanese yen is rising against the euro.

That is forcing money managers to go farther afield to find new ways to create the same trade. Today, many are borrowing in Europe, where the euro is at 12-year lows and interest rates are at rock-bottom levels.

Their money is finding its way to India and Indonesia and in some cases the Philippines and Sri Lanka. And, in a scenario few could have imagined a few years ago, some investors are putting their money in higher-yielding U.S. Treasurys, betting the dollar will continue to rise as the Federal Reserve raises rates.

Eric Stein, co-director of global income at Eaton Vance Management, with $295.6 billion under management, has been shorting, or selling, the euro and buying India’s rupee-denominated government bonds and Indonesian rupiah sovereign debt.

“Typically, you wouldn’t think of funding trades for rupees with euros,” Mr. Stein said. “You can think of it as an unconventional way to fund some of these Asian trades.”

A $10 million investment in the Indian rupee would generate $600,000 a year, Mr. Stein estimated, while negative interest rates in the eurozone would bring an additional $40,000 by betting against the euro. But movements in exchange rates of either currency could boost or pare gains on the trade, or even lead to losses.

Mr. Stein is among foreign institutional investors who have bought $5.89 billion of Indian debt so far in 2015, according to India’s National Securities Depository Ltd., more than the $5.8 billion in the same period last year. They have also bought $3 billion of Indonesian government bonds in the same period, helping stabilize benchmark 10-year yields since the beginning of the year.

India and Indonesia are especially popular because investors are more confident that new leaders in both countries will bring stability, growth and economic change, providing incentives for longer-term investment alongside higher interest rates.

The rupee is especially popular as it has fallen far less against the greenback over the past year than many other emerging-market currencies.

The surge of cash into these developing economies has already had effects on currencies and interest rates, helping to bolster growth. But it has also sparked concerns among investors and policy makers worried that, as quickly as the money has flooded in, it could also rapidly flow out, causing wild swings in financial markets.

Paul Lambert, head of currency at London-based Insight Investment Management (Global) Ltd., with £362.5 billion ($553.28 billion) of assets under management, said the recent bout of volatility in foreign-exchange markets has made employing the strategy difficult.

He has reduced his positions across the board, including the euro, in part because “we think we’re in a higher-volatility environment.”

Others, though, are sticking with it. Singapore-based Dymon Asia Capital Ltd., one of Asia’s largest homegrown hedge-fund firms, said it benefited from betting on the rupee against the euro in January, in an otherwise difficult month for the fund following volatility in other areas of the currency markets. A spokesman for the firm, with more than $4 billion in assets, didn’t respond to requests for comment.

The euro is popular because of the eurozone’s low interest rates and aggressive monetary easing that have sent the currency tumbling 23.1% against the dollar since 2013. Hedge funds and other speculators see more losses to come, holding the most bearish positions in nearly two years, according to the Commodity Futures Trading Commission.

“Monetary policy in the eurozone supporting the euro trend makes it a no-brainer for using the euro as a funding currency,” said Paresh Upadhyaya, director of currency strategy at Pioneer Investments.

The asset manager, which oversees $246.2 billion, also sells the common currency to buy rupees and Indian sovereign bonds, as well as rupiahs and Indonesian government debt.

Some investors who want to avoid the thrills of emerging markets are even heading back to the soaring greenback.

UBS AG said it has a small position borrowing and selling euro-denominated high-grade bonds, such as German bunds, and buying dollar-denominated high-grade bonds, such as U.S. Treasury notes. The firm also recommends the rupee and Indian equities to its clients.

“It’s hard to find any kind of growth in emerging markets,” said Kiran Ganesh, cross-asset strategist at UBS Wealth Management, with $1 trillion under management. “India is one of the few countries in the emerging markets that has good and even accelerating growth. That makes it a good candidate for carry strategies.”

Indeed, as I explained when I went over CPPIB's risky bet on Brazil, emerging markets are fraught with risks in this environment. Among the group, India is in the best relative shape, which is why it's the beneficiary of enormous liquidity flows but all that hot money can come out as fast as it came in.

And as I stated in my comment on the mighty greenback back in October 2014, " I wouldn't be surprised if it (EUR/USD) goes to parity or even below parity over the next 12 months." If this happens, expect to see more euro funded carry trades in India, Indonesia and elsewhere, placing even more pressure on the euro.

But for now, all eyes are on the Fed and the big question this week is will it stop being patient? I still maintain that if the Fed raises rates in June or August, it will be making a monumental mistake.

Importantly, the surging dollar has already tightened U.S. financial conditions and raising rates and risking a full-blown emerging markets crisis will only reinforce global deflation, an outcome that the Fed and other central banks desperately want to avoid.

But as Brian Romanchuk reminds us in his recent comment, Fed Rate Hike Cycles And Bond Yields, there are a lot of uncomfortable lessons for bond bulls from these past (rate hike) episodes:

Are they underestimating the acceleration of the labour market, as in 1994? Is too much emphasis being placed on the external sector, as in 1999? And finally, have bonds adequately priced the path of rate hikes? After years of Fed rate hikes continuously receding into the future, the next several months may finally be interesting for U.S. interest rate analysts. (Unless a downturn intervenes, in which case we will have to start listening to the hawks about how rate hikes starting in June 2016 are a certainty.)

I happen to think not enough emphasis is being placed on the weakening global economy, especially the ongoing slowdown in China's economy, which slowed at its sharpest rate in the first two months of the year since the global financial crisis, heightening fears that this deceleration will undermine global growth (Read the latest from Sober Look, Is China's growth slower than the 7% consensus?).

Stay tuned, it will be a very interesting summer and second half of the year. All these carry trades can be unwound at a moment's notice, wreaking havoc on global stock and bond markets. But as I explained in my Outlook 2015, even though it will be a rough and tumble year, there will be plenty of opportunities to make money in risk assets:

In this environment, investors should overweight small caps (IWM), technology (QQQ or XLK) and biotech shares (IBB or XBI) and keep steering clear of energy (XLE), materials (XLB) and commodities (GSG). And even though deflationary headwinds will pick up in 2015, I'm less bullish on utilities (XLU) and healthcare (XLV) because valuations are getting out of whack after a huge run-up last year.

I stick by all my stock, currency and bond calls. In fact, if global investors listened to me, they would have made a killing shorting the euro and going long U.S. bonds and stocks (especially the sectors I recommended when I told them to plunge into stocks) and shorting commodities and the commodity currencies like the CAD. I'm still short Canada and think the crisis is just beginning here (Read Brian's latest, Canada Reaching The Wiley E. Coyote Moment).


Below, Marin Katusa, chief energy investment strategist at Casey Research, discusses the oil price crash, the US Dollar, weakness in China, and the ongoing economic crisis with RT (March 9th, 2015). Listen to his comments, he raises several excellent points, explaining why the weakness in the commodity and energy sector will continue in 2015 and 2016.

And Morgan Stanley’s Hans Redeker appeared on Bloomberg recently, stating the U.S. dollar is only about halfway through what analysts at the bank are calling a super-cycle that compares with other large moves going back to the 1980s. Listen to his comments here as he's more favorable on the effects of the surging greenback. I'm not as convinced that the unwinding of the mother of carry trades will end nicely but enjoy the ride, for the time being.