When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

Business Loan Chart
Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

3m Swap
Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

3m Libor
Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.

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Filed under: Fixed IncomeInterest RatesInvestment IdeasMarket CommentMarket PsychologyMarket Theory

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