Good Evening: After a couple of wobbly sessions on Friday and Monday, U.S. stocks resumed rising on Tuesday. With little in the way of economic news, it was left to a falling dollar to buoy investor risk appetites. The greenback obliged by setting a new low for 2009, and commodity prices understandably reacted by heading in the opposite direction. Interestingly, however, Treasury yields and credit spreads didn’t rise with renewed dollar weakness; they instead fell. Falling interest rates and rising equity values may cause the FOMC to issue a statement of self-congratulations after their two day confab breaks up tomorrow, but what our central bankers may not realize is that one of the important policy linkages for the levitation in our asset markets is the greenback itself. Carry trades are back and the new funding currency of choice is the U.S. dollar.
Stocks around the world were mostly higher overnight. Japan remained closed, and while China’s CSI 300 dropped more than 2%, other Asian markets and most of Europe’s bourses were quite firm. Thus encouraged, U.S. stock index futures were modestly higher as Tuesday’s opening bell approached. The economic data was a non factor in today’s trading. Weekly chain store sales results were disappointing; a government measure of home prices rose; and the Richmond Fed survey reading of +14 in September showed no improvement from August. Stocks opened 0.5% higher and traded mostly sideways until the results of the Treasury’s latest auction results were posted.
Despite a tiny yield of just over 1%, the demand for the $43 billion (a record) of 2 year notes was the strongest since 2007. Central banks took down approximately half the auction and the bid-to-cover ratio was well over 3. The major U.S. stock market averages hit their highs for the day just before these results hit the tape, and they spent the rest of the day hovering within shouting distance of their best levels. The NASDAQ (+0.4%) slightly trailed the other indexes, while the Russell 2000 (+0.8%) sported the best gain. As mentioned, Treasurys rallied and their yields fell between 3 and 10 bps. The greenback was clobbered at the open and never once lifted its head off the canvas. The U.S. dollar index fell 0.9% and set a new low for 2009 in the process. Commodity market participants were emboldened by the hapless buck and they found little resistance as they pushed the CRB index almost 2% higher on Tuesday.
“How”, starts a typical question I’ve been asked this month, “can stocks, bonds, and commodities continue to rise together?” My briefest response is “money printing”, and a more nuanced version of the same reply describes how risk appetites have been rising due to low interest rates and quantitative easing. Only the most persistent readers are unsatisfied by this explanation. “Why?”, or “what’s the linkage between the two?” come the dogged responses, as well as the ever-popular “who is doing all the buying?” In addition to disgruntled shorts and unhappily underweight portfolio managers, the busiest buyers these days are hedge funds and bank proprietary trading desks. They are putting on carry trades, and the latest funding currency of choice is none other than the U.S. dollar (see below).
For the uninitiated, a word of explanation is in order. A “carry trade” is any trade whereby an entity borrows money and uses the proceeds to buy assets. The money borrowed is short term in duration (usually overnight) and the assets purchased are longer term ones — ranging from 30 days (commercial paper) to infinity (equities). In the broadest sense, almost any asset can be bought with borrowed money and end up on the right hand side of the ledger in a carry trade, but the vast majority of carry trades take place in the fixed income world. Banks effect such trades every day, borrowing in the fed funds market and buying 2, 3, and 5 year notes, hoping to earn the yield differential in the process. Almost always, this yield differential is positive, giving an investor what is called “positive carry” (hence the name carry trade). The classic carry trade is done in one’s home currency, and the assets purchased are usually government securities with short and intermediate maturities. If this trade sounds easy, it is. But this trade carries with it the risks that the overnight borrowing rate can rise, that the asset purchased can fall, or, as in 1994, a dastardly combination of both.
Let’s return to the original question of linkage between Fed policy, rising risk appetites, and the role carry trades play in boosting asset prices. If banks borrowing in the fed funds market to buy short term Treasurys is the “classic” carry trade, then it shouldn’t surprise you to learn that hedge funds and the prop desks of large financial institutions often take the carry trade to more sophisticated heights. The desks at these shops will borrow overnight to buy corporate debt, leveraged loans, and even high yield debt. Not content to stay at home, they will also shop worldwide for the lowest overnight rates in which to borrow, and they will likewise engage in a global search for the most beguiling assets. In addition to the risks facing the classic carry trade, these global carry trades have an added one: an inconvenient rise in the currency in which they have borrowed.
Managing these multiple risks requires that traders putting on carry trades in currencies other than their own be confident the borrowed currency will stay weak. For almost two decades, the 98 pound weakling currency targeted for borrowing was the Japanese yen. In the wake of the bursting of their twin bubbles in both stocks and property in late 1989, Japan’s economy has been a basket case and the BOJ has kept short term interest rates at microscopic levels. Except for the occasional eruption and rush by borrowers to cover shorts, the yen mostly stayed weak during this period. The yen carry trade was so profitable it became a prime tool of global speculation. When the global panic of 2008 hit, the yen rallied fiercely as risk appetites shriveled and forced carry traders to sell assets and pay off their yen denominated debts. Why, then, if risk appetites have been rising for months, has the yen not fallen under the weight of new carry trades?
The answer is that the currency getting sand kicked in its face these days is the U.S. dollar. Back in March, our Federal Reserve pushed the fed funds target toward zero. When dollar-based LIBOR rates eventually followed, the cost of borrowing in dollars to effect carry trades fell below the cost of borrowing in other major currencies. According to a piece put out by Capital Economics this morning, “(o)ne explanation for the dollar’s weakness is its increased use as a funding currency. The 3 month interest rate differential between the U.S. and a weighted average of its major trading partners has swung from more than 2% a few years ago to below zero today”. What’s more, the Fed’s quantitative easing program, which involves the purchase of billions of Treasurys and mortgage-related securities, effectively put a floor beneath the prices of these securities.
With the lure of a weak currency, the lowest borrowing rates in the world, and a central bank willing to backstop the bond market, speculative capital the world over is finding its way here. The Fed has turned King Dollar into a source of princely profits for global carry traders. Until the perception of a weak dollar changes — whether due to a shift by the Fed to a more stringent monetary policy or to a sudden cooling in risk appetites — the market moves we’ve seen since March could be with us for a while. In this environment, the greenback could remain friendless — even with bullish sentiment for the buck fetching less than a dime. To answer the original question, the dollar can continue to fall and dollar assets can continue to rally as long as the dollar carry trade continues to live.
Catalysts which might upset this happy state of affairs for our markets and our central bank are numerous, but they include the Fed itself. If tomorrow’s FOMC meeting produces a policy statement which overtly entertains the notion of an exit strategy, it is possible the latest dollar carry trades could start to be unwound. Another potential negative catalyst for risk appetites is this week’s G-20 meeting. If the politicians propose some new and goofy regulatory framework that somehow makes it harder for the hedge funds and prop traders to make money, then this news, too, could set off a correction that sees stocks and commodities fall against the backdrop of a rising dollar. And, of course, there is always the possibility of an exogenous shock that will cause those currently gorging on risk to see some of their positions make a reverse journey through the financial equivalent of the alimentary canal. Until some event occurs, however, rising risk appetites and the dollar carry trades that feed them will be a large influence on asset prices.
– Jack McHugh
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