Is the Carry Trade Returning to the Markets?

Just to briefly touch on the economic reports released yesterday, we had a measure of small business and economic optimism. Both reports are second tier but the National Federation of Independent Business showed that confidence among small companies rose to a three-year high in January. We also had a measure of job openings that seems to contradict that rise in optimism. Job openings fell in December to 3.06 million, the fewest since September, and fewer small businesses in the US said they plan on adding payroll.

Couple that with the disappointing jobs jamboree figure and it appears the lower number of openings isn’t a result of increased hiring. I guess higher optimism helps breed future job growth, so hopefully we’re beginning to set the foundation.

The last data point was a weekly consumer confidence figure, which showed a fairly large drop. Again, this really isn’t a major market mover and can show some wild weekly moves. We’ll see a larger gauge of confidence on Friday with the U. of Michigan Confidence report but until then, all eyes are looking toward the weekly jobless numbers tomorrow. We do get another weekly report due out today with the MBA mortgage applications gauge. As we have seen the 10-year rising quite a bit lately, I wouldn’t see much in the way of progress in this department.

Moving on to the currencies, the dollar remained under pressure for the better part of yesterday and most of the gains in early trading remained in tact. Many of the top performers on the day were the high yielders with the Swiss franc (CHF) and Canadian dollar (CAD) bringing up the rear. We’ve seen this type of action before, so let’s go to Chuck and get some thoughts…

Mike is giving you the updates, so I think I’ll just talk to you about something that I’m seeing in Japanese yen (JPY)…

I’m beginning to see cracks in the yen foundation, folks. And with interest rates rising around the world, I’m thinking that the carry trade might make a return to the markets… You find that when risk aversion begins to fade, that risk trades, like the carry trade, will begin to become the norm again. So, for all of you new to class, or to all of you who have forgotten… The carry trade is a simple trade full of risk and potential reward… An investor simply sells a low-yielding currency (yen), and uses the proceeds to buy a high-yielding currency, thus booking the yield differential between what it cost you to borrow the yen to sell it short, and the interest you receive from the high-yielding currency…

All is well, as long as the yen doesn’t rise or Japan doesn’t raise their interest rates, and as long as the high-yielding currency doesn’t lose value, or the central bank doesn’t cut interest rates. Before the financial crisis of 2008, the carry trade was all the rage… But after things went to hell in a hand basket, carry trades were unwound, thus propelling Japanese yen to 25-year highs versus the dollar. Well… I fear that this may all be turning around once again… And when it hits its stride, yen will no longer be the currency to own… It would, in my opinion, lose its so-called “Safe Haven status”…

Just my opinion, folks… For what it’s worth…

Thanks Chuck for giving me a kick start this morning and it certainly makes sense to me. With all of the optimism floating around not only with global growth but also here in the US, it seems investors are becoming more and more complacent with risk. With that said, market volatility needs to remain muted in order for the carry trade to be effective so increasing comfort with the European and US economic uncertainties will definitely be needed.

Looking at the big winner from yesterday, the Brazilian real (BRL) appreciated by just under 1% and prospects of higher interest rates seemed to be the culprit. The fuel added to the fire was an increase in January consumer prices by the fastest pace since 2005. The monthly rate rose by 0.83% and translated into a 5.99% annual figure. The usual suspect for higher inflation at this point, food prices, was in play but they also have domestic demand contributing to these uncomfortable levels as well.

We now have traders starting to price in a rate hike for a second straight time next month, so that sent the real well into the 1.66 handle. While central bank officials claim inflation threats will fall as the year wears on from cuts in government spending and other unrelated costs, it seems the market isn’t so confident. The median target for interest rates by year-end among economists is still at 13%. I guess we’ll see how comfortable the central bank really is with inflation at their next meeting, but they are still standing behind thoughts of moderation.

We also saw the New Zealand dollar (NZD) and South African rand (ZAR) both rise about 0.5% as they were buoyed by the high yielders ascent from an easing of Egypt’s political problems. Again, South Africa wouldn’t be included on our favorites list, but they did make news yesterday as a result of their unemployment rate falling from 25.3% down to 24%.

This is the highest jobless rate of the 61 countries tracked by Bloomberg, so not exactly a positive. Rates don’t appear to be moving upward any time soon either, so any appreciation from the rand would come from gold or the coat tails of the other high yielders instead of its own merit.

The belle of the ball so far this year, the Swedish krona (SEK), posted yet another day of gains against the dollar and actually reached a 10-year high against the euro (EUR). This movement is primarily a result of the “risk on” sentiment in the market, but the Swedish economy has also been quietly chugging along. When you talk about Sweden, you also have to talk about Norway. The krone (NOK) found itself barely in the black yesterday but jawboning from government officials about currency gains have kept it restrained recently.

Looking at the other end of the spectrum, the Swiss franc had a rough day by falling about 0.75% against the dollar. The same factor at play that pushed Brazil upward had the opposite impact on the Swiss franc. Since the franc is a low-yielding currency that’s viewed as a safe haven, periods of higher optimism and risk exposure will do nothing to help the currency. This selloff came at the same time when the seasonally adjusted unemployment rate dropped to the lowest since April 2009. I would say the carry trade was in play yesterday.

Lastly, the market reaction to China was interesting. With the previous rate hikes, we saw significant selloffs in the risk assets on thoughts the Chinese government would slow their economy to the point where global growth would take a hit. I guess everyone is starting to figure out that tapping the brakes once in a while isn’t a bad thing and actually helps to keep the train on the tracks. In other words, just because China raises rates doesn’t mean their economy will come to a screeching halt.

We saw the US equity markets post gains yesterday, we saw gold rise about $15 and silver about $0.90, and we saw the dollar index down on the day so I think Chuck was right on the money yesterday when he said the Chinese didn’t surprise anyone. Additional hikes look inevitable at this point, so as long as growth scenarios in the US and Europe remain in tact, I think we’ll continue to see this type of market non-reaction from Chinese rate hikes.

As I came in this morning, everything is trading pretty much where I left them last night. The New Zealand dollar and South African rand have seen some selling pressures overnight, but other than that, all was fairly quiet. The dollar index is up slightly so far this morning but not much in the way of direction thus far. We do have Bernanke set to speak today so we’ll see if he says anything out of the ordinary, but I’m sure he’ll stick with the script of keeping interest rates low and focusing on jobs.

To recap…Another slow day for economic reports here in the US. The high yielders gained while the low yielders fell, so we are starting to see the carry trade re-surface. Brazilian inflation is still rising and South African unemployment drops to 24%. The Swedish krona rises against both the dollar and the euro while the Swiss franc had a tough day. The markets switched gears and blew off China’s rate hike.

Mike Meyer
for The Daily Reckoning