Three Important Consequences for the Return of the Carry Trade

It started in Asia. Now it’s spread westward to Europe. And before it’s all over, it might even reach the United States.

Swine flu?

No. “It” is rising interest rates and an end to the free flow of easy money that flooded the globe in response to the 2007-08 financial crisis. The world’s monetary mandarins are deciding, one by one, that it’s time to close up the spigot, if only a little.

It began last October, when China raised interest rates. Three more increases have followed, the most recent on Tuesday.

In Europe, despite an agreement to bail out Portugal to the tune of some $100 billion, the European Central Bank (ECB) voted this morning to bump up its benchmark lending rate for the first time since July 2008 — from 1% to 1.25%.

“Central banks increase interest rates when they want to slow down an economy that may be overheating and generating too much inflation,” explains our currency trader Abe Cofnas. “The central banks’ rate hikes reveal a new commonly shared sentiment: fear of inflation.

“Essentially, it is a huge tectonic shift in the fundamental forces that move currencies. For traders and investors, it’s also a great opportunity. When a central bank changes interest rates, it creates an imbalance in capital flows. Those imbalances ripple through almost every currency traded.”

“This is due to the ‘carry trade,’, where in which investors sell or borrow currencies with low interest rates and use that capital to buy currencies with higher interest rates.”

“The carry trade was a very big deal just a few years ago,” Abe says. Japan maintained bargain-basement rates in a futile attempt at stimulus. “Borrowing yen to invest in higher-yielding currencies was an almost guaranteed way to make money.”

That came to an end during the Panic of 2008. The whole world began turning Japanese, slashing rates. And borrowers had to bring their capital back home to pay off their debts.

So how can you keep a pulse on the carry trade? “Just watch the iPath Optimized Currency Carry ETN (ICI),” Abe says. This exchange-traded note (similar to an exchange-traded fund) uses the carry trade as an investment discipline. Any gains in ICI reflect a strengthening carry trade.”

Abe is closely watching the $47 level on this chart. “If it breaks above this price, it’s a clear signal that the carry is back!”

iPath Optimized Currency Carry ETN

So what if the carry trade is back? Abe sees three consequences…

  • “The yen will once again be a good target for carry traders. With rebuilding from the earthquake a priority, Japan favors a weaker yen.”
  • “If rates in the rest of the G-7 countries continue increasing in the coming months, the Brazilian real will become more vulnerable to a sell -off.” Brazilian interest rates are an eye-popping 11.75%, but just a narrowing of the spread with other countries could end up weakening the real.
  • “The dollar is still a low-yielding currency and may also suffer from the carry trade effect. In other words, traders may push the dollar’s value down as they sell greenbacks and purchase other currencies.”

One huge caveat: “If Fed Chairman Ben Bernanke signals that quantitative easing is not likely to be extended, or signals vigilance on inflation, traders may anticipate a rate hike.”

For clues to what might happen, Abe took the minutes from the March Fed meeting and plugged them into a “word cloud” to see how often certain words turned up:.

Inflation Word Cloud

“Clearly, the word ‘inflation’ came up a lot,” Abe says, “and that doesn’t bode well for low interest rates. Still, we won’t know for sure until the next Fed meeting” on April 27.

Addison Wiggin
for The Daily Reckoning