from Follow the Money

The dollar is no longer a high carry currency …

March 21, 2007

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That at least is what the market seems to think.  The carry trade has bounced back

The Australian dollar -- a high carry currency -- is setting new highs (v. the US dollar at least).  The kiwi has recovered.   Iceland's krona has been fairly resilient in the face of a rating downgrade.  The Malaysian ringit and Thai baht are heading back toward their 1998 levels.  The Indian rupee -- a new carry trade destination currency -- has been doing well.   And, judging from the strong ongoing growth in Brazil's reserves, inflows in Brazil have continued.  Brazil's reserves are up $5.5b so far in March.  China's low interest rates (and capital controls) keep the RMB from being a destination currency, but its stock market has bounced back -- hot money doesn't seem to be shying away from China, or perhaps Chinese money isn't heading out of China even with higher interest rates in the rest of the world.

The US dollar, by contrast, is once again rather weak.  Especially against the Euro.  1.34 is back to the dollar's lows of 2004 and early 2005.  The Fed may be on hold -- and, if Dr. Roubini is right, about to cut.   But US rates are still higher than eurozone rates, let alone Japanese rates.  

So why -- as Teis Knuthsen of Danske bank notes -- has the dollar diverged from the high carry currencies?

After all, Australia, New Zealand, Iceland, India and Turkey all have current account deficits, and all but India have large current account deficits.  How can the Aussie dollar be strong and the US dollar weak when both offer a yield pickup over the euro and yen?

Two thoughts:

One, most of the currencies of other current account deficit countries offer a bit more carry than the US dollar.  So if you are going to finance a country with a big deficit, why not finance the country that offers the most yield?  That is the logic behind my Deutsche Bank friends' recent recommendation to go long Turkey v. South Africa.   The same logic may apply globally. And if you want carry and don't want to finance a current account deficit, there is always Brazil.

Two, on an absolute scale, the deficits of even Australia and Turkey -- let alone tiny countries like New Zealand and Iceland -- are fairly small.  Japanese households looking for yield could easily finance the entire current account deficit of New Zealand.  Swiss private bankers (or Swiss households) could do the same for Iceland.   All any of these small countries need to do is offer a bit more attractive risk/ reward combination than the US and get a small fraction of the global flow of funds.

The US external deficit, by contract, is quite big.  As Alberto Musalem Borrero notes, the carry trade is far too small -- even taking the biggest estimates -- to meet the United States roughly $850-900b financing need.  And that is just what the US needs to cover its current account deficit -- it needs to borrow even more if it wants to increase its holdings of foreign assets.

The US deficit is bigger than China's (not small) surplus, Japan's (not small) surplus and the oil exporters' (not small) surplus.   You need to sum up all three big surpluses to come close to meeting the United States need for financing.

And there are a host of signs that the financing of that deficit has gotten a bit more difficult recently.   The dollar's weakness against the euro is one.   But so to is the acceleration in global reserve growth.  Stephen Jen -- quite accurately in my view -- has noted that global reserve growth is now close to $80b a month.  That is about $1 trillion a year.  Throw in $100b or so in non-reserve Chinese foreign asset growth in state banks and state companies and $100b or so in non-reserve growth in the oil investment funds, and total official asset growth (counting the Chinese banks as part of the official sector) is potentially close to $1.2 trillion.

That is more than enough to finance the US deficit.   As Stephen Jen notes, inflows from emerging economies are the fundamental source of all the liquidity sloshing through the markets. 

The ‘real’ sources (i.e., the world’s savings-investment surplus) of global liquidity remain robust:  the Asian countries and the oil exporters continue to generate some US$800 billion worth of combined C/A surplus.  Global long-term interest rates, as a result, have remained near a generational low.

Those looking for a reason why real rates in all the advanced economies that are on the receiving end of these inflows -- largely official inflows -- need look no further.   Mohammed El-Erian of Harvard now believes emerging economies are a source of stability (hat tip: Global Liquidity Blog). They have been willingness to finance the US when others won't.

But the official sector also doesn't just want to add dollars to its portfolio.

Alberto Musalem Borrero implicitly contrasts the carry trade with official inflows (after all, those official flows play a bigger role in financing existing large deficits at current prices).  But I am increasingly interested in the intersection between the carry trade and global reserve growth.  Think of a hedge fund borrowing yen to buy Brazilian real or Indian rupee, and thus fueling Indian and Brazilian reserve growth.  Both India and Brazil then invest some of their growing reserves in the US.   That is one way of financing the US deficit --

But it is a bit less "efficient" than a hedge fund borrowing yen to buy dollars.  Brazil keeps most of its reserves in dollars, so it does its part to sustain the current unbalanced world.   India -- like Russia -- only keeps about 1/2 its reserves in dollars.  And with Indian and Russian reserves both growing fast, global reserve growth consequently has to exceed the US current account deficit if official investors in the emerging world are going to finance the US deficit ... or so it seems.

It is an interesting world. 

And it could be an even more interesting world if the Fed actually starts to cut -- and global demand for dollars falls further.  A slowing US economy will cut into the trade deficit, but the overall US current account deficit may not fall that fast.  I think the income deficit is set to rise sharply.  And that means that even a slowing US that doesn't offer much of a yield pickup over the rest of the world would need to attract a very large share of the world's spare savings.