Carry Trading the Falling Dollar

FUND STRATEGY: The latest FOMC statement contained specific language signaling prospects for more quantitative easing in the coming months. As always, Fed talk says if only necessary, but the report shows lagging data leading up to that moment of, well, necessity in their minds. The markets pretty much believe that there will more treasury purchases to keep borrowing rates low - as a monetary stall of stimulus. We see the Fed desperately trying their powers amidst midterm elections, where true fiscal policy is needed, but will have to wait, probably until early next year.

So, here's the opportunity. The dollar is decreasing against a basket of competing currencies, so a short dollar position in the FOREX market is the prime choice for traders. Ben Slotnick, one of our readers, messaged me about the advantage of using arbitrage through carry trades. This works by taking advantage of the interest rate spread between the US and emerging countries. Since borrowing costs are very low in the US, investors will naturally borrow but with the purpose to sell dollars in exchange for another currency with high deposit rates; thus pocketing the spread of cash exchange. The country that has high deposit rates is in the process of withdrawing monetary stimulus; countries like Australia and India. The risk is that exchange rates fluctuate, causing the value of the currency exchanged to possibly cancel out the purpose of profiting on a spread.

The current conditions show a trend that will likely continue throughout the rest of this year. The screen-shot from CNN Money shows the overall picture of bonds and rates. The recent uptick in yields is from better economic data (durable goods), but analysts say that yields are still in a zone of resistance.

Banks, who are adjusting investments during these times of government desperation, are profiting. As the Fed tries to crowd out the treasury market to encourage banks to transport cash away from government debt to borrowers, the banks will result to carry trades. This will place more downward pressure on the dollar, benefiting short dollar traders in the FOREX markets, and hopefully benefiting policy makers who are apparently wise enough to realize the externalities of their actions. On a quest to lower the dollar's value, policy makers are probably planning to export our way to recovery. Again, this doesn't work well for a reserve currency that's subject to high fluctuation. Germany may have benefited from a weak Euro, but it's not enough to help the entire Euro-zone escape its troubles.

But, think about it. Banks are sitting on a good amount of cash while the government tries to stimulate. Once we have better fiscal policies that effectively stimulates growth, and the Fed calms down, banks will feel comfortable to lend their excess cash. Also, if exports do pick up manufacturing will become more productive which will create jobs. Banks will lend, until Bassel III rules and financial regulation standards kick in. At this point, counter party risk will be an issue, so long as we sustain a recovery.