The Return of the Carry Trade?

The currencies continued to their stampede over the US dollar yesterday, with several reaching fresh highs. The Dow Jones average moved above 10,000 again, so everything must be alright in the world economy now, right? This morning the dollar bounced back up, but it just looks like profit taking and not a more permanent trend. Lots to talk about today, so I’ll get right to it.

The dollar dropped again yesterday as investors continued to move money out of the ‘safe haven’ investments in favor of higher returns. The two places where investors sought refuge during the economic crisis were the US dollar and Japanese yen (JPY). Investors felt a level of comfort in the currencies of these countries because they are the world’s largest and most advanced marketplaces. With the credit crisis gripping the globe, investors were satisfied pulling money off the table and ‘parking’ the funds in ultra low-rate accounts in Japan and the United States.

With the latest data showing the global recovery taking hold, investors have moved out of these low rates and have sought out higher returns. Some of this money has flowed into the equity market in the US, pushing the Dow Jones average back above 10,000 (more on that in a second). The global recovery also has investors looking toward commodities, which were beaten down on fears of a global slowdown. The price of copper, gold, and crude oil have all run up on fresh signs of a global recovery. With commodity prices coming back up, the countries that are commodity rich should do well, and investors have returned to the currencies of Canada (CAD), Australia (AUD), and Norway (NOK).

Finally, investors who feel more confident have begun to take on a bit more risk, with many returning to what was once a very profitable trade: the carry trade. This trade dominated the currency markets for a number of years prior to the global economic crisis. While long-term readers know all about it, I will give another quick explanation for those of you who are new to the Pfennig. The carry trade is simply a trade where investors borrow at low interest rates and then invest the borrowed funds at higher interest rates. The trade typically uses a high degree of leverage in order to make even a small interest rate differential profitable. The most popular funding currency of the carry trade had been the Japanese yen, as interest rates in Japan were held at near zero levels for several years. Investors would borrow the yen at 1%, sell the yen and use the proceeds to purchase New Zealand dollars (NZD), and then invest these kiwis at a rate of 5%; earning the spread of 4% (before fees). As long as the currencies remained relatively stable, the profits rolled in. The risk to this trade occurs when the funding currency starts to move up versus the investment currency, and the leverage used can make these currency moves pretty dramatic.

But enough of the history lesson; let me get back to where we are today. The US dollar has replaced the Japanese yen as the most popular currency for the carry trade. Investors have been selling dollars and moving funds into the higher returns of Brazil (BRL), South Africa (ZAR), and even Mexico (MXN). These countries have the attractive combination of high interest rates and commodity-based economies that should do well in a global recovery. But as I mentioned above, investors in these carry trades can be a bit fickle, and can reverse these trades at the first sign of trouble. These currencies can be volatile, and should be viewed as the speculative portion of your currency investments.

The last few months have been a sort of ‘perfect storm’ for the currencies of Australia and Norway. Both have benefited from the surge in commodity prices. Both also have strong governments that kept their respective economies from dipping too far into recession. Because of this fiscal strength, both countries are now raising interest rates, which continues to make their currencies more attractive. The Norwegian krone climbed to a one-year high against the euro (EUR) and the dollar yesterday as crude oil prices jumped. With Norway putting a percentage of their oil revenues to work rebuilding their economy, their central bank will probably start raising rates at their next meeting. The Norges bank governor Svein Gjedrem said last month the bank had considered raising rates at the September 23rd meeting and will likely have to take a fairly aggressive stance on rates going forward.

Australia was the first to raise interest rates, and will likely continue to tighten. Reserve Bank Governor Glenn Stevens told reporters that the RBA can’t be too timid in raising rates now that the threat of an economic crisis has passed. “If we were prepared to cut rates rapidly, to a very low level, in response to a threat but then were too timid to lessen that stimulus in a timely way when the threat had passed, we would have a bias in our monetary policy framework.” Unemployment is falling, and consumer confidence continues to rise in Australia, which will likely mean additional interest rate increases in the next few months.

Investors in our newest WorldCurrency Index CD have been perfectly positioned for these latest currency moves. We introduced the Global Power Shift CD back in July of this year and it has been one of our best performers. This CD combines Australia, Brazil, Canada, and Norway into one mighty index CD. Ty Keough mentioned the other day that he had spoken to one of the first investors in the Global Power Shift, and had calculated the customer had earned an amazing 12.5% during the first three months (that is a 50% annualized return!!). With commodity prices continuing to push up, and interest rates set to rise in both Norway and Australia, investors should continue to see good returns in this WorldCurrency Index CD.

As I mentioned above, the Dow Jones average moved back above 10,000 yesterday. Investors have apparently taken the same view as the Nobel Peace Prize committee and are betting on the ‘good things to come’. I just don’t see any concrete evidence of a sustainable recovery here in the US. Unemployment continues to hover near double digits, and US foreclosure filings have climbed to a record high. While ‘less negative’ numbers on the retail sales may have inspired some mis-directed optimism, the US economy is still in a very precarious position. I know equity investors always have to look at ‘future’ cash flows and purchase stocks on the promise of earnings coming in somewhere down the road, but I don’t see where the current data supports a Dow at 10,000.

The retail sales numbers reported yesterday here in the US were ‘less negative’ than expected, dropping 1.5% versus a predicted 2.1% drop. The press proclaimed the return of the US consumer confidence since this number was better than predicted. I guess as long as the data comes in a bit better than what the economists predicted it is positive (no matter what the actual data is!). Today we will see data on consumer prices, which are predicted to show that inflation continues to be muted. The volatile Empire Manufacturing report will also be released this morning and will show another jump.

If the inflation data come in as expected, the news will give the upper hand to FOMC members who have said the central bank can keep interest rates low for a long time. The minutes of the FOMC September 22-23 meeting showed that some members were actually calling for an expansion of the ‘quantitative easing’ program. Chairman Ben Bernanke said the Fed is prepared to tighten credit when the economic outlook ‘has improved sufficiently’. But the minutes show that the Fed is actually leaning toward a more expansionary program. There seems to be absolutely no fear of future inflation, so look for rates to remain low for some time to come. This will continue to keep downward pressure on the US dollar.

I wrote yesterday how the US is following the BOE’s lead when it comes to ‘quantitative easing’. These programs had led to a drop in the value of both the UK pound sterling (GBP) and the US dollar. But overnight, the pound sterling stormed back up versus the US dollar as The Financial Times cited the BOE Markets Director as saying policy makers would be more likely to pause asset purchases, giving themselves the option of ‘doing more later’, rather than stopping them. A report yesterday showed that UK unemployment rose less than forecast last month causing some of those investors shorting the pound to reverse course. I have to believe a lot of the pound’s movement is simply profit taking after the sterling lost 3.5% versus the US dollar in the past month. I still believe the pound sterling will have a tough going as long as they continue with their QE programs.

I will end today’s Pfennig with a prediction from Goldman Sachs. You may have seen where Goldman reported another quarterly profit of $3.2 billion yesterday. The profit is really no surprise when you understand just how far ‘inside’ Goldman is with the administration. Given their position, I always like to read what Goldman is predicting for the currencies. Their latest report said the dollar is likely to extend drops against the euro and commodity-backed currencies over the coming six months (sound familiar?). The euro is now predicted to reach $1.55, revising previous forecasts of $1.45. “It now looks as though the dollar trough will be slightly deeper,” Goldman analysts said.

The Daily Reckoning