Those who do not remember the past are condemned to repeat it.
- George Santayana
For those who have not been paying attention, the U.S. dollar (USD) recently posted a 15-month low last week as it continues to be sold across the board. The dollar fell to 1.5050 dollars per EUR, down from $1.25 just 8 months ago. The USD declined over 10 percent against the Japanese yen to 89.00 per dollar, from a high 100.00 in April 2009. The Australian dollar (AUD) led the pack, soaring over 45 percent in the same time period reaching .9370 today. The rationale for the dollar losses has mostly been a better risk appetite for global investors, or as many would say, "risk on." And there appears to be very little reason for this trend to reverse course.
The Carry Trade
The USD has an exceptionally low interest rate, fueling an environment for use of the dollar as the carry trade financing currency. The dollar, therefore, tends to fall when investors are open to a riskier portfolio of buying stocks, commodities and other currencies, when interest rates are higher. The most conspicuous example is the recent rise in the Australian dollar. Currently, the 3-month USD LIBOR rate is now near .27 percent while the AUD LIBOR is near 4 percent. Such a yield differential will naturally attract investors to borrow USD and invest in the AUD. Under these circumstances, supply and demand dictates- that the USD goes down and the AUD goes up.
With the U.S. unemployment at 10.2 percent, no one should be surprised at last week's Federal Reserve Bank's commitment to keep interest rates low. In fact, many believe the Fed will be among the last major bank to fully remove liquidity. The vote was unanimous (10-0) to keep the Fed funds rates in the 0 percent to 0.25 percent target range. The Fed statement included "that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Meanwhile, in Australia economic conditions have been stronger than expected. Employment numbers have improved with the unemployment rate seems to be peaking at 5.8 percent. Growth in Australia's key trading partners has improved and stronger-than-expected domestic economic data continues to justify interest rate hikes by the Reserve Bank of Australia.
According to Bloomberg, in 2009 investors have preferred to be overweight currencies in the G-10 carry trade strategies. A strategy of being long a basket of the three highest yielding G-10 currencies (which for the most part has included the AUD) and funding those positions by being short the lowest yielding G-10 currencies (JPY and USD), has generated annualized returns in 2009 of around 38 percent. While some commodity currencies, like those of oil exporters Canada and Norway, have a slightly different story. Both have led the way in the dollar's 2009 across-the-board decline. The market believes that improving financial conditions will lead to stronger global growth, which should then have a rebound in commodity prices, which in turn should help support an advance in the commodity currencies. You only need to look at higher oil prices and record high gold prices to see the correlation.
In addition, the recent G20 meeting highlighted that global monetary "accommodation" would remain for some time. And since there was no specific mention by the group's financial leaders about dollar, or any currency in particular, the FX markets continued selling the dollar. This may have reinforced the belief that, for now, carry trades could remain a viable investment strategy.
But before putting that short USD/ long AUD position, you should be aware that such strategies have tremendous risk. There are two very difficult things to really know about carry trades — how large and deep is the collective set of carry trades and what exactly triggers an unwinding. The risk of such trades usually peaks when global economic conditions change. However, history shows there is one certainty: when the consensus carry trade unravels as a result of "risk off", the unwinding tends to be abrupt and unpleasant.
The Japanese yen is a classic example how a persistent, easy monetary policy encouraged the use of a currency as a funding vehicle. For years, the Bank of Japan's zero interest-rate policy kept Japanese short-term interest rates trading near zero. The low level of Japanese interest rates had encouraged investors to sell the yen, thereby exerting downward pressure on the yen and contributing to the underperformance of yen assets. During the 1990 Asia crisis when these carry trades were unwound, supply and demand reversed course. The result was that the yen rose nearly 35 percent from August 1998 through October of the same year.
In addition, there is growing concern from some central banks about the falling dollar. In the Euro zone, industrial production rose for a fifth month, increasing a meager 0.3 percent in October after a 1.2 percent gain in the previous month. The Euro zone reported a mere .4 percent expansion of Q3 GDP, its first rise since Q1 2008, which shows that the economy has finally moved out of recession. However, rising unemployment and a stronger EUR threaten to undermine the recovery. Europe's jobless rate increased to 9.7 percent in September, the highest since January 1999. The EUR has gained 20 percent against the dollar since mid-February, making European exports that much more expensive. In the U.S., Treasury Secretary Geitner recently said it is very important that the "U.S. has a strong dollar and recognizes that the dollar plays an important role in global stability."
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
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