Just Another Funding Currency?

"Beware of geeks bearing formulas."

- Warren Buffett

Ever since the financial crisis began in the summer of 2007, and especially since Lehman Brothers failed in September last year, the doom and gloom folks have been warning that the United States could face a future similar to Japan's lost decade. There were several similarities at the outset; real estate and banks were a large part of the problem, rates were cut dramatically and quantitative easing was used in both cases. However, ever since the stock market began to rally in March this year, that sort of talk has been replaced by a far more optimistic view of our future prospects. Time will tell whether such optimism is warranted.

One similarity that still exists today is the impact on short-term rates. Dollar rates have fallen steadily; it began with the Fed cutting official rates, followed by falling market rates as the credit crunch eased and spreads compressed. As of last Friday, three month USD LIBOR was 0.3475 percent, about 4 basis points lower than the equivalent JPY LIBOR - the last time this happened was 16 years go.

In addition, as rates have fallen, the dollar has begun to react to market forces much like the JPY has done ever since the Bank of Japan began quantitative easing in 2001.

The JPY lost ground steadily versus most currencies from 2001 until the beginning of the financial crisis in 2007, as money poured out of JPY and into risky assets and markets and speculators invested in "carry trades." In a simple version of the carry trade, a speculator would borrow a low interest rate currency like the JPY, sell JPY and buy a high yielding currency (AUD, NZD, BRL, GBP and others were commonly the currencies of choice). By doing this, they would earn the "spread" between a low cost of borrowing and a higher yielding investment. For most of those years, they often were rewarded by capital appreciation as well, as most of those currencies strengthened versus the JPY. Once markets began to fall and risk aversion set in, many of these trades were unwound and the JPY strengthened precipitously on the crosses, causing large losses for those in carry trades.

That pattern continues today - when risk appetite is on the rise, equities, commodities, risky assets and higher yielding currencies rise and the USD and JPY fall. The reverse is also true - when markets fall, the USD and JPY benefit. Despite the fact that USD and JPY rates are virtually identical, the JPY tends to outperform even the USD in times of risk aversion, perhaps indicating that for now it remains the "true" funding currency in carry trades.

Assuming dollar rates stay low for some time, as appears likely, will the dollar become another funding currency like the JPY? While that appears to be the case for now, I don't see that continuing for more than a few months, for a few reasons. Some have to do with the future of carry trades as a speculative vehicle, while others relate to basic differences between the situation facing Japan then and the U.S. now.

Carry trades are not as prevalent today, as speculators are less willing to make leveraged currency bets. Many of the carry trades were created and sold by hedge funds and investment houses to speculators; as their ranks have thinned and as margin trading availability and leverage has declined, so has the volume of these transactions. In addition, option volatility remains somewhat elevated compared to a few years ago, raising the cost of hedging these trades, which used to be a fairly common practice.

Turning now to the difference between our situation and Japan's a few years ago, capital flows play a significant role. In the early part of this decade, a major factor contributing to JPY weakness other than carry trades was an outflow of domestic Japanese savings to other markets. With very little foreign capital flowing into Japan to offset it, downward pressure on the JPY increased and made speculators far more sanguine about establishing short JPY positions. Flows into and out of the USD are far larger and more complex, consequently more difficult to predict and at least for now, far more supportive of the USD, which raises the risks of being short the USD.

Finally, it was obvious to most market participants that Japan had very little chance of a sharp recovery in the early part of this decade. Confidence was low, the presence of zombie banks curtailed lending, the real estate slump continues even today, while the stock market at its peak in 2007 remained about 20 percent below the 1995 peak. As of last week, it is over 50 percent below the 1995 peak. For our economy, there is far greater uncertainty about the future trajectory of the economy. While we may in fact languish for a year or two with little or no economic growth, there is a chance that growth could rebound more strongly. That would result in rate hikes and a stronger currency. The mere specter of two-sided risk will keep most speculators at bay.

In conclusion, while the USD may behave like the JPY currently, this is probably not going to last. In the near term, it is likely to remain under pressure when times are good and appreciate when risk aversion rears its ugly head. Over time, however, it will begin to react to the fortunes of our economy and in particular to the likelihood of the Fed raising rates. Keep an eye on the employment situation; when our economy starts producing jobs, it may be time to load up on dollars, especially versus the JPY.