You’re Living in the New Japan

Back in the day when the carry trade was in full force, traders all around the world were looking to sell the yen. They basically rented the yen to buy other high yielding currencies like the Aussie dollar, New Zealand dollar and British pound.

However, today is a new day. Oh sure, the yen is still a great candidate…don’t get me wrong. But as Chuck mentioned on Monday, there’s a new contender in town that is rivaling the yen for the “funding currency” title….

…The U.S. dollar.

Why the greenback? There are plenty of reasons…

For starters, interest rates in the U.S. have never been this low. The Fed has kept interest rates between a range of 0% to 0.25%. (Japan’s rates are at 0.10% right now.)

You see, Japan had low interest rates to borrow at and they had a horrible economy that held their yen down too. On top of that, many of their largest companies LOVE a weak currency because their exporters prosper when their yen is “cheap.”

dWhy Americans Actually Want a Cheaper Dollar

Well what do we have here in America?

1. Low interest rates
2. A horrible economy
3. We love our cheap currency

Let’s talk about reason #3: There are plenty of Americans lobbying for a cheaper currency right now, as strange at that sounds.

The reason? Many of our biggest companies within the Dow and S&P 500 make most of their money overseas…not in America. So these huge U.S. conglomerates earn most of their profits in euros, pounds, etc, but then they have to repatriate their assets. Companies need to convert those foreign profits back into dollars.

If the dollar is weak, it looks like they have a lot more dollars on their U.S. balance sheets. This gives U.S. companies an incentive to push for a weaker dollar too.

Frankly, this all makes us a little TOO much like Japan for comfort. Japanese authorities did the same thing for the better part of the last decade. They pushed down the yen’s value so their Japanese companies could be more competitive on the world stage.

Dollar Takes It Place Among Carry Trade Currencies

Then of course, we also have the super-low interest rate, which means the dollar is now a carry trade candidate.

Why didn’t this happen before? Just two years ago, the U.S. still had a respectable interest rate. As long as the dollar had a higher interest rate, it didn’t make sense for traders to use it as a funding currency for the carry trade.

The whole point of carry trading is to keep the spread between a high yielder and a low yielder. If the spread doesn’t pay, there’s no reason to buy.

After all, would you rather borrow a currency at 0.25% and invest that money at 6%? Or borrow at 3% and invest that money at 6%? In the first example, you get 5.75 basis points (5.75%) in the spread. The second example only gives you 300 basis points (3%).

It’s a no-brainer right? That’s exactly why carry traders were choosing the Japanese yen over the dollar to fund their currency trades until recently.

But in the last two years, our Federal Reserve and Treasury have so fully debased our currency that it makes the dollar a very enticing funding currency for the carry trade now.

In fact, now traders are borrowing both the yen AND the dollar to fund their carry trades. Then they’re buying up higher yielding currencies like the South African rand, Turkish lira, Australian and New Zealand dollars.

Stocks Go Up, the Dollar Goes Down: Perfect time for Dollar Carry Trade

Currency Crosses to Buy as This Carry Trade Takes Off

Now there’s plenty of funding choices for carry trades once the economies of the world start to recover and inflation is spurred once again to a point to where interest rates begin to be raised yet again. When this happens, unfortunately, you can remember the greenback as one of those funding choices.

When this happens, you won’t just be restricted to buying AUD/JPY, NZD/JPY, etc. as before. Now you’ll be able to buy AUD/USD and NZD/USD as your carry trades too.

The only thing that will negate that from happening is if the Fed ends up raising interest rates far sooner and far more aggressively than they’ve stated. When and if that’s the case, then you can just switch back to “old faithful”…the yen carry trade.

Happy Trading,
Sean Hyman, aka “Professor FX”

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