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There
is no “dollar carry trade”. Yes, FOREX traders are short the U.S.
dollar in massive proportions and part of the reason for this is the interest
differential they receive when buying, say, the Australian dollar/U.S. dollar
pair (over 3% annualized). But there is no “dollar carry trade”
in terms of investors or speculators borrowing U.S. dollars and using them to
acquire assets denominated in other currencies. Not because this
wouldn’t be a splendid idea, but simply because there is nobody lending
dollars to investors, much less speculators, at the present time.
The
latest pundit to join the false “dollar carry trade”
fearmongering is Nourel Roubini, the NYU professor of economics nicknamed
“Dr. Doom” for his predictions about the recent economic
collapse. Roubini claims that:
“There
is a wall of liquidity…chasing assets,” Roubini told “Squawk
Box.”
“Now
we are in the mother of all carry trades,” he added.
Asset
prices have been inflated by the cheap funds but the dollar cannot keep
falling forever, and there could be “a market crash all over the
world” when the currency’s course is reversed.
But
this will not happen too soon as the real economy is still very weak and the
Federal Reserve is likely to keep interest rates close to 0 percent for
longer, Roubini added.
“The
reality is that the dollar is the funding currency of the carry trades. Because
of that the dollar weakness is going to continue for a while.”
This
is utter nonsense. I challenge Roubini and anybody else who is spouting these
“dollar carry trade” proclamations to identify the specific
entities involved as well as their sources of borrowing. They can’t,
because there aren’t any.
The
fact is that U.S. banks are holding unto money tighter than ever. They are
reigning in lending and raising interest rates to punishing levels in order
to drive customers away (as Citibank has recently done with
its credit card portfoli0). They are definitely not making new risky loans to
speculators engaged in carry trades involving the dollar or anything else.
According
to the latest FRB Release H.4.1 - Factors Affecting
Reserve Balances, banks are holding more than $1 trillion
in reserve balances on deposit with the Fed. Up until a few months ago, most
of these reserve balances were borrowed under the various Fed rescue programs
such as the Term Auction Credit, which peaked near $500 billion in March and
has declined to $130 billion recently. Today, most of the reserve balances
held at the Fed are the result of outright purchases of U.S Treasury, agency
and mortgage-backed securities from the banks pursuant to a policy of growing
the Fed balance sheet. This is referred to by many as
“quantitative easing” or “QE” but it is actually a
systemic monetization. True “QE” would discourage the banks from
parking money with the Fed in the form of reserve balances. In contrast to
Japan’s efforts to fight deflation in the past 20 years, U.S. banks are
actually paid by the Fed to maintaim reserve balances. If and when the Fed
charges banks for maintaining reserve balance instead of paying them, then we
can talk about QE.
Indeed,
when we look at the FRB Release H.3 -
Aggregate Reserves of Depository Institutions and the Monetary Base, we
can plainly see that non-borrowed reserves have climbed to almost $800
billion in October 2009 while borrowed reserves have dropped below $300
billion. This is a direct consequence of the Fed monetizing bank assets by
acquiring them for cash in the form of reserve balances. Inasmuch as the vast
majority of the assets purchased from the banks are “risk-free”
— U.S. Treasuries and U.S. government-backed mortgage securities
(Fannie Mae, Freddie Mac) — it is necessary for the banks to either
earn higher interest or achieveless risk on their newly-acquired
reserve assets in comparison to the interest or risk they have foregone by
selling the assets in the first place. Less risk is clearly achieved by
holding reserve balances at the Fed, and in fact the banks even earn higher
risk-adjusted interest on such balances compared to lending excess reserves
to other banks under LIBOR or the overnight facility.
And
here is where the “dollar carry trade” argument shatters and
falls apart. We are expected to believe that a bank would sell to the Federal
Reserve a “risk-free” government or agency security (yielding at
least 1-3%) and subsequently lend the proceeds at around 0% interest so that
a hedge fund can speculate by acquiring a risky asset denominated in another
currency. Utter nonsense. Especially considering the banks are currently being
paid 0.25% on reserve balances. Not
coincidentally, LIBOR is currently about 0.25% in the short maturities as
well.
To be
clear, there are market participants other than banks who have unloaded U.S.
Treasuries and agency securities to the Fed over the past 6 months. Among
them are the central banks of countries such as Russia. But these entities
have used the proceeds to diversify out of the dollar and into securities
denominated in other currencies, not to fund a dollar carry trade. They are
not chasing global assets prices. Moreover, they are obviously not acquiring
U.S. equities. So how to explain the rapid rise in asset prices over the past
6 months?
Well,
for one the markets have been rallying from a very low base reached in
November 2008 - March 2009. For example, the U.S. stock markets were down
over 50% from peak to trough. At the same time, oil was down about 80%. For
two, it is natural for markets to retrace some of their losses for technical
reasons involving market psychology while having nothing to do with
underlying fundamentals or requisite structural changes in money flow (as
would necessarily result from a “dollar carry trade”). For three,
some markets have clearly benefited from the moderate amount of
diversification out of the U.S. dollar that has taken place. These include
gold, the euro, the yen and emerging economies that export commodities. For
four, we cannot ignore the massive government stimulus programs that have
injected trillions of dollars in liquidity on a global scale. Some of these
dollars have no doubt leaked out and found their way into the hands of
speculators. For five, most pundits and especially economists make the
mistake of treating markets as a homogeneous group of participants and
therefore they are not able to recognize important internal shifts. In the
case of the global markets, the fact is that a large group of investors were
able to avoid, by moving to the sidelines as the crisis unfolded, the big
losses suffered among the buy-and-hold crowd. This sidelined money was (and
is still) substantial. Only a trickle coming back into the markets was
required to boost asset prices once the last of the weak buy-and-hold hands
capitulated earlier this year. It has hardly been a “wall of
liquidity”.
In any
case, we believe all of the above factors are temporary and do not create
a long-term fundamental basis for markets to continue moving higher
indefinitely. Thus we agree with Roubini about the eventual reversal even if
we don’t agree with him about the reasons for it. For example, it is
not a “dollar carry trade” but diversification out of the dollar
(which too has frequently been overstated in the media by pundits) combined
with the trickle of sidelined money (held primarily in cash and U.S. Treasury
securities) that has been the key reason for dollar weakness over the past
few months. A reversal of these trends, not any change in the “dollar
carry trade”, will mark the reversal in the markets as well. Along
these lines, we humbly note that both the diversification out of dollars and
the trickle of sidelined money back into the markets have been made
almost-singularly possible by the Fed’s ballooning balance sheet.
Indeed,
we argue that the critical consideration going forward is how the markets
will react when the Fed slows down and eventually reverses its monetization
program. The question is timely because there are already signs that the Fed
is in the process of winding down or even suspending System purchases. For
one, the $300 billion of targeted U.S. Treasury security purchases has been
reached in October and the Fed has not announced an extension of this
program. For two, the Fed’s open commitment to purchase mortgage-backed
securities has fallen to a rate of $150 billion on a rolling basis, which
implies that most future purchases will come from new loan origination and
not existing securities acquired in the market. For three, the Treasury Department
continues to withdraw money from its reserve account with the Fed, which
effectively increases the amount of money held by banks. This creates a
source of liquidity for the banks to start repurchasing securities from the
Fed. Some of this liquidity has probably leaked out into the markets, but
there isn’t very much of it left at this point (down to $60 billion
from over $200 billion at the end of August).
So,
assuming the Fed is in fact slowing down its purchases (and even possibly
getting ready to reverse some of them) and such purchases have had an
overriding impact on the direction of the markets during the past six months,
what should we expect going forward? Well, there are some pundits who have
mistakenly assumed that an impending slow down in the Fed’s securities
purchases will mean a weaker dollar. While this is possible, their argument
is apparently based on the nonexistent “dollar carry trade”,
which will purportedly intensify as the Fed’s departure from the
markets is expected to immediately foster another crisis focused on U.S.
banks. Another faulty argument is that dollar (bag)holders will accelerate
their rate of divestiture as higher U.S. interest rates will push down the
value of dollar-denominated debt remaining on their books.
We
say, don’t count on it. The nearly $800 billion in non-borrowed reserve
balances held at the Fed represent an effective bulwark in the short run
against the next stage of the financial crisis. At a minimum, a
liquidity-induced panic would not originate at U.S. banks. Moreover, a
meaningful bump in U.S. interest rates as the Fed slows its outright
securities purchases should create demand for dollar-denominated debt,
especially on the short end of the yield curve. This would more than offset
any pre-emptive selling on the long end. The main reason for such an outcome
is that the Fed has capacity to rebalance interest rates because its recent
purchases have been made predominantly in short to mid maturities. As a
corollary, Treasury issuances have also been predominantly in the short to
mid maturities. Here is what we stated on June 3rd and the situation has
changed little since then:
We
wonder if much of the weakness in Treasuries on the long end of the yield
curve has been the result of foreign sales (possibly including China). In
addition, we note that the Federal Reserve has done little to defend long
Treasury rates, preferring to do much of its buying in the middle of the
yield curve. This is only speculation on our part, but the reason for this
might be to create future flexibility to bring down long rates fast and hard
should the need arise and once the foreign selling has abated. To do this,
the Fed would simply sell from its short-term Treasury portfolio and buy for
its long-term Treasury portfolio.
While
banks are arguably on a much stabler footing with respect to liquidity than
the past couple of years, the non-bank credit markets such as money market
funds and corporate debt continue to be quite vulnerable to shifts in
sentiment. Tighter liquidity in these markets would remind market
participants about the risk of leverage during periods of credit contraction
and many would flee at the first sign of trouble.
In
conclusion, we posit that the recent uptick in the dollar, as well as the
apparent topping action in many asset classes including equities, commodities
and corporate bonds, is the result of smart money beginning the process of
deleveraging in anticipation of moderate credit contraction as the markets
adjust to the Fed suspending its more aggressive pumping activities. Such
deleveraging necessarily creates demand for the U.S. dollar. The top-heavy
distribution of speculative dollar shorts completes the recipe for disaster.
Putting
it all together, a coeval correction in all markets may lie directly ahead,
similar to but not as severe as the ubiquitous debacle that took place
between September 2008 and March 2009. Any impending monetary crisis is
likely to primarily involve banks outside the United States that have not
used the past few months to build up formidable reserves. Our guess is that
Chinese banks may play a central role due to the fact they have continued to
aggressively leverage themselves in anticipation of a recovery that is still
years away. The most vulnerable assets are likely to be those predicated on a
weaker dollar including commodities and emerging markets. Timing is not
certain and the situation is subject to change should the Fed, for example,
decide to extend the purchase of Treasury securities. But as things stand, we
feel it is prudent to heed the Fed’s current path, which is not toward
“QE” but rather away from it.
Tom Szabo
Silveraxis.com
Also
by Tom
Szabo
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