Monday, 1 March 2010

Carry trades

Most people would think that a carry trade consists in borrowing in a currency with low interest rates (typically Swiss Franc) and investing in a currency with higher interest rates (let us say Icelandic Krona, just for illustration), the idea is to pick up the interest rate differential which is supposed to be the reward for the currency risk involved in the transaction.

As of late, the meaning of carry trade has changed a bit. It now appears that the interest rates are not important any more, which is quite evident, given that interest rates are close to zero everywhere. So carry trades now means borrowing in a currency which is expected to weaken against other currencies.

Since Dollar weakened against pretty much all other currencies from March to December 2009 (losing some 13 per cent against the Euro), the market began to talk about the "Dollar carry trade". News media have now begun to report that some investors are beginning to "worry" about the dollar carry trade, meaning that the dollar will continue to appreciate. At the same time, Wall Street Journal Friday printed an article stating that leading NY hedge fund managers have decided to gang up and try a "career trade" against Euro.

Europe should be so lucky! It would be just what we needed. Europe would truly profit from a weaker currency and the quicker the better. So if some hedge fund managers can help us, so much the better.

The English language financial press is prone to present any news about a weaker Euro as a sign of the Union's imminent demise. In this case, Greece's perennial budget problems are the reason.

Conversely, a stronger euro is rarely – if ever – presented as a sign of the strength of the European project. Usually you have to read the French, German, Belgian and possibly even the Italian financial press to get that view on things.

If we try to ignore all this political talk, the situation is that from the beginning of the European downturn, the Euro has been the currency that strengthened the most against pretty much everything: Dollar, Sterling, Yen, Swiss Franc, Swedish Krona. There has been little talk about this fact and even less talk about the fact that Europe's economic recovery would be significantly hampered by the surging Euro. But it is now visible in the European growth data.

In my mind there is no doubt that the Euro needs to weaken and by quite a bit in order to escape the worst effect of the "beggar-thy-neighbour" policy openly implemented by our friends and allies. The only question is by how much and how quickly.

Using my own indicator, the Euro can fall far. This indicator simply says that if Europeans are willing to travel to NYC to go shopping and come home laden with shopping bags, dollar is too weak. If the good burghers of my native Copenhagen are willing to sit on a bus for two hours to go shopping in Swedish Malmö on the other side of the Sound, then the Euro (and by extension the DKK) is way too strong.

Some are talking about parity between Euro and Dollar. Why not? In 2002 a Euro would buy only 85 cents. After the most recent 10% weakening, it still buys $1.35, still a whopping 60 per cent increase. Nothing in the relative productivity growth justifies that increase.

Would it not create inflation? Probably not as long as the potential output gap is as big as it is now. More expensive import goods, then? Yes, but that is the whole point of a weakening currency, that the domestic products gain in competitiveness.

And the speed of adjustment? Everybody loves to see things develop smoothly and in a straight line, not too quickly. The truth is of course that if the Euro were to weaken quickly, it would cause some disruption, once things stabilise everything settles back to normal.

So please, do not fear for the "dollar carry trade" when it can be turned into a "euro carry trade" instead. NYC hedge fund managers, please do not waste your time on too many "idea dinners". Do something, go ad sell some Euros short.

It would even make it easier for Greece to handle her economic situation.

No comments: