The Fed, the Carry Trade and the Misleading Bubble

The current carry trade consists of shorting the dollar against other currencies and simultaneously taking long positions in futures of commodities such as gold, other metals and oil or emerging stock markets. The term “carry” means that the position is financed or “carried” with a loan in the low yielding currency to profit from positions in higher yielding liquid assets. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade at the turn of the millennium consisted of shorting the yen because of the near zero interest rates of Japan and simultaneously taking positions in high yielding currencies such as the Australian dollar and the New Zealand dollar. The Japanese yen (JPY) depreciated by 40 percent versus the US dollar (USD) in 1995-7, reaching an eight-year low of JPY147.26 per USD on August 11, 1998. In October 6-9, 1998, the JPY reversed the strong trend of depreciation and appreciated 15 percent versus the USD. The IMF observed a “cascade” of USD/JPY selling by institutional investors including hedge funds. There were no resulting shocks to the economy of Japan or the world economy but this episode has been used as illustration of instability caused by unwinding carry trades. The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years. These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. Central banks should not induce these swings of financial variables. The credit/dollar crisis carry trade consisted of shorting the dollar and simultaneously going long in oil futures that reached $145/barrel in September 2008. The alarmist proposal of TARP in the second half of September 2008 caused a crisis of confidence, analyzed by Cochrane and Zingales, which encouraged panic inflow into dollars, reversing the carry trade with the price of oil collapsing toward $40-$50 per barrel. The combination of the 0-0.25 percent fed funds rate with the recovery of confidence and risk appetite encouraged the current carry trade with devaluation of the dollar toward $1.50/euro and increase in gold futures prices by 64 percent to $1150/ounce. Governments threatened intervention in oil futures routing the carry trade to metals futures. The fluctuation of the dollar without piercing forcefully $1.50/euro reflects two related problems. First, traders are fully aware of the aggressiveness of the Fed in raising or lowering interest rates by hundreds of basis points. A minor change in perception of Fed policy could cause appreciation of the dollar, collapse of gold prices and major losses in the carry trade, explaining the hit and go behavior of dollar positions. Second, the Fed balance sheet in the last monthly report shows holdings of securities of $1690 billion, with the largest holdings of $775 billion of treasuries and $774 billion of agency-guaranteed mortgage-backed securities; the major item of liabilities is $1083 billion of deposits at the Fed by depository institutions or banks. The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). If the economy recovers more rapidly than in the current outlook of the Fed, banks will want to withdraw their deposits to earn higher interest from loan spreads than what the Fed pays in interest. The Fed would raise interest rates, increasing the marginal cost of lending of banks and thus the short-term interest rate. The Fed would also have to sell in the market about $1.7 trillion of securities, lowering their price which is the same as increasing their yields. The entire yield curve would shift upward, which means increases in both short and long-term interest rates. The dollar would appreciate unwinding the carry trade. The misleading use of the term “bubble” in the context of the carry trade and others implies that market participants are ignorant and follow trends recklessly while governments and analysts after the fact are rational and never err. The fact appears to be that traders have protected the funds entrusted to their management by taking defensive positions against the shocks of policy that threaten to reduce the wealth of their clients, which in this case is a zero interest rate. The problem of the credit/dollar crisis has not been positions by investors or unsound lending by banks but the aggressive, shifting, fast changes in central bank policy of hundreds of basis points and trillions of dollars. What is needed is not more regulation of banks and finance but rather recognition of the ambiguity of knowledge on central banking and less volatility in policy impulses. The aggressive change in interest rates in attempts by central banks to stay ahead of the lag in effect of policy by half a year or more caused the credit/dollar crisis and global recession by distorting risk/return decisions throughout the economy (Pelaez and Pelaez, International Financial Architecture, 18-28, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). Central bank balance sheets of trillions of dollars have created a tough adjustment trap complicated by a fiscal deficit of more than 10 percent of GDP with the federal debt approaching 100 percent of GDP. The adjustment to the monetary and fiscal stimulus can restrict growth and job creation. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )