Sunday, September 20, 2009

The US Dollar Carry-Trade is Financing Dangerous Global Currency Speculation

As readers here know, we are gravely concerned with the current chaos on world currencies and the  collapse of the US Dollar. French newspaper Le Monde says the USD is now the "vedette" of speculators. With interest rates so low in the US, it is the chose mechanism, just like Japan's Yen was.

The situation is scary for those invested  in money markets are other such instruments considered "safe", as we have also mentioned many times.

The USD was the currency that was used as the world's refuge and safehaven during the financial crisis, but is now used by carry-trade speculators. This consists of borrowing money in currencies where rates are lowest then investing this money into currencies that pay more.

This raises a huge red flag with certain currencies. The emphasis is mine.

Since late August, the U.S. interest rates fell below the rates of Japan and Switzerland. They are referring to the practical rates for banks. Speculators who, since the spring, had borrowed money in Yen and Swiss francs to invest it place in markets where rates were higher (such as the Australian dollar or the New Zealand dollar or, and this is my concern,  the Brazilian Real - see my post on Brazilian inflows), are now using the USD dollar. The also invested in raw materials and commodities.

To implement these "carry trade" strategies, they need to sell the borrowed dollars, thus the USD was under great pressure, and the currencies in which they were reinvested exploded.

Le Monde adds: "Since March, the New Zealand dollar has risen 43% against the dollar."  The central bank said that if the appreciation of its currency continues, it could jeopardize the country's economic recovery. "A warning should not be taken lightly, say economists at BNP Paribas. ( ...) It would not be surprising to see the central bank intervening in the event of further increases in the New Zealand dollar against the USD. The United States is a major trading partner of New Zealand, unlike Australia, which deals mainly with Japan and other Asian economies.

Rates still low, and too low

So far, the speculators have been unable to make the dollar fall sharply against the euro. While gold has now crossed the threshold of 1,000 dollars an ounce, the dollar has suddenly stalled, sending the Euro to its highest level since September 2008. Le Monde says that economists do not rule out seeing the Euro soon exceed $ 1.50. In fact, "a very big investor blocked for several days the market so that the dollar did not fall below the level of 1.4450 USD for 1 Euro. But this position did not resist, Tuesday, at the power of the dollar selling wave that followed the summit of G20 finance this weekend of September 4 and 5 September,  and this has caused a panic, "said Sebastien Galy, currency strategist at BNP Paribas.

The bankers have realized that the cost of borrrowing money will stay low for a long time and they could continue to speculate. Dissapointing econimic data might even encourage investors to take risks and make aggressive moves in emerging markets to the extent that there will be no quick exit from the fiscal and monetary policy expansionary in industrial countries, says the  BNP Paribas.
Thus the prudence of central banks could turn against them.  If they leave rates low for too long, they may create bubbles.

Following a monetary policy ultra-flexible conducted since 2001, the Bank of Japan long hesitated in 2006 before starting to normalize its monetary policy. They feared causing imbalances in light of the considerable sums that speculators had the time to borrow yen at very low rates in operations of Japanse carry trade. In March 2006, however, it decided to reduce the facilities it gave to banks. A year later, in February 2007, they began to raise interest rates.

This is a very risky and unstable situation. Straddles are a favoured way to take advantage of this explosive and volatile conditions. We will be updating our post on USD straddles this week.

UUP Chart with Bollinger and RSI7:

(please click to enlarge chart)

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