Wednesday, September 2, 2015

Cross Border Money Flows And The Carry Trade

Carry Trades Often Hide In A World Of Shadows
The words illusion and mirage are both very interesting and can conjure up strong images. Both these words may be relevant to the financial markets of today that in many ways have grown far less transparent due to speed at which transactions occur and the complexity of our modern world. Often when we look behind the curtain we find the products of sophisticated traders are highly leveraged and stack layers of risk upon the huge amount of risk that already exist. When we mix in the impact of derivatives and its sister "shadow-banking" the water gets really murky.  The recent moves of central banks entering equity markets and government pension funds becoming big buyers of stocks speaks volumes as to how the red flags of caution are being totally ignored.

Many of the bets placed in the financial casino known as the global market are shrouded intentionally or merely by the nature of the transaction. This can easily move them into the area of "carry trades" or some other highly leveraged trade that could fall into the field of derivatives. Derivatives fall into many categories from futures, options, credit default swaps, and any complex combinations of these. They can also be used to wager, bet, and spectate on a market move or direction. Regulation is difficult and spotty at best in that a derivative transaction in one country might be considered a simple spot trade in another. Many of these transactions that appear on the surface as simple are in reality a bet on a bet on a bet. Remember this is only part of a much larger market that includes hundreds of trillions of dollars in non-reported agreements and private contracts.

Nothing can be more disruptive to an economy than cross border money flows and the carry trade. Both these practices have dramatically increased over the years as the central banks of the world have been engaged in the mass printing of money and keeping interest rates artificially low. Such an economic environment screams for gamblers to come forth and enter these games in search of quick gains and easy money. In reality much of this is totally out of the control of central banks, or that of any regulatory agency, but because of their actions it goes on everyday unregulated and indirectly cheered on by central banks throughout the world. Also troubling is that people make money in the process of structuring and selling these agreements. Those in these trades or who buy and write derivatives often play fast and loose with the value of the collateral backing them or flat out lie about it. 

The central banks and the too big to fail have thrown open the casino doors with low interest rates and easy money and this has allowed carry trades to flourish. It is only reasonable that we have seen an explosion in "highly leveraged recipes for profit" since 2008 when the carrying charge for such trades dramatically decreased. The Financial Time defines a carry trade as a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market. For example, in the period up to 2007 many investors borrowed in Japanese yen or Swiss francs, taking advantage of very low interest rates in Japan and Switzerland, and used the money to take long positions in countries or currencies backed by high interest rates or where it is thought the currency might be particularly strong.

The carry trade exploits small differences generally in a highly leveraged environment in the hope of banging out a profit. This means the strategy is dependent on relative stability in asset prices and an adverse exchange rate movement can quickly wipe out the returns from the underlying interest rate differential. This leads some to refer to the carry trade as akin to picking up pennies in front of a steamroller. For years the best example of the carry trade at work in a world of open financial borders can be seen by studying Japan. The yen carry trade reversed sharply in 2007 as global interest rate differentials narrowed. This is what caused the yen to rally against many currencies. In my opinion it is also what has bolstered the yen in recent weeks but I don't feel it will last very long this time. For years a strong yen kept a lid on Japan’s market, as the money flowed overseas. But as interest rates fell around the world, money started flowing back to Japan pushing the yen lower and Japan’s market higher.

Decade Low Interest Rates Have Make Japan A Key Player
We sometimes have to wonder just how much the central banks consider this in their overall scheme of economic control. As you can see on the chart below Japan has kept interest rates low for nearly 20 years. The Bank of Japan cut rates to 0.5% in late 1995. The rate has been at that level or lower since then. It’s currently 0%: However, the interesting factor isn’t so much Japan’s rate on its own, rather it’s the rate compared to other country’s rates. For example, in January 2008, Japan’s rate was 0.5% while Australia’s interest rate was 7%. In such a situation it is only logical that traders were borrowing at close to zero and then parking their money in higher yielding Aussie bonds and stocks. It was like getting "money for nothing." However, in most cases today the spreads are much narrower and the trades contain far more risk.

In the end when the dominoes known as "world currencies" come under pressure and begin to fall, the direction in which they fall will make a great deal of difference in the financial landscape we are left to face. Many of those involved in over-leveraged schemes might best be described as "too clever by half" if they think they have successfully controlled the risk or removed the implications and problems a default would cause. History shows that following the success of such schemes those who benefit often cannot resist the temptation to return to the well with even a bigger version and try again. In our complex and fast moving global market where money moves across borders in the blink of an eye this adds a huge degree of risk and uncertainty.

Footnote; As always your comments are encouraged. World Central Banks have been on this murky path for a long time, please see the following posts. One deals with how this has detached from reality and other looks at how if a meltdown occurs many people will use it as a reason to adopt a new "world currency"

More recent articles concerning what is happening in the currency markets are listed below,


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