The Era of the Dollar Carry Trade

The Aussies made it official early this morning… if it wasn’t already, the dollar carry trade is on.

The Reserve Bank of Australia hiked its main interest rate yet again today, up another 25 bps, to 3.75%. That’s the third rate hike in as many months for Australia, which is enjoying a healthy consumer comeback and many of the spoils of the China boom.

Whether the Aussie economic comeback is legit or not, there’s now at least a 3.5% spread between interest rates in the U.S. and down under. If you desire a strong dollar, that’s not good.

“For years, the carry trade was simply assumed to mean borrowing Japanese yen to fund a trade with any other currency,” explains our currency trader Bill Jenkins, “essentially borrowing at a low rate to collect higher interest rates elsewhere. As a matter of fact, the first man who ever taught me the carry trade put it in just those terms: ‘The carry trade is when a currency trader sells the Japanese yen in order to buy the U.S. dollar.’

“But now the values have changed. The yen is not the sole currency employed in the carry trade. Large investors all around the world now sell the U.S. dollar in order to fund their trades of virtually all other currencies.

“In case you’re still not clear on the concept, essentially, this is how the carry trade works: A trader sells a lower-interest-bearing currency and then uses that money to purchase a higher-interest-paying currency. He must pay the interest rate on the currency he borrowed, but he receives the interest on the currency he bought. His profit on the trade is the difference between the two currencies. For instance, if he sells the U.S. dollar now with its 0.1% interest rate and then buys the Australian dollar with its 3.75% interest rate, he makes the difference on the spread between the two — or 3.65%. Not a bad way to make a little income on nothing more than parked cash.

“But the longer this goes on, the harder it is on the dollar. Because it means that more and more people are selling dollars, and that does indeed push the price down. In just the same way that when a lot of houses are for sale on your street and then you decide to sell also, you are not going to get the same price as you would have if you had been the first person to sell. When supply goes up, demand goes down. And when demand goes down, so does price (value). Here in the United States, we have been creating a larger and larger supply of dollars. That drives down the value. And when more and more people are selling, that further drives down price. From where I see it, those who deal with the dollar daily — namely, us — are in deep trouble.”

The market has responded to this unsavory reality by pushing the dollar index down over half a point. It was just above 75 at midnight yesterday, and now it’s barely clinging to 74.4, its lowest since November 2008. At $1.51, the euro is at a 15-month high.

The Daily Reckoning