Carry Trade Favors Demand for Foreign Currencies

Investors in dollar-denominated assets will see lower interest rates in the U.S. than in almost all of the rest of the world. The “carry trade” will favor demand for foreign currencies at the expense of the dollar, according to Russell Investments’ chief economist Mike Dueker.


Investors in dollar-denominated assets will see lower interest rates in the U.S. than in almost all of the rest of the world.

The “carry trade” will favor demand for foreign currencies at the expense of the dollar, according to Russell Investments’ chief economist Mike Dueker. The carry trade refers to investing in currencies with higher interest rates to harvest the interest-rate differential.

This interest-rate differential between the United States and the rest of the world changes the breakeven rate of currency depreciation between hedged and unhedged currency exposures.

For U.S.-based institutional investors, the unhedged position beats the hedged position if the foreign currency depreciates at a slower rate than the interest-rate differential (or if the foreign currency appreciates by any amount). Currency trading represents one of the assets institutions favor in the eclectic alternative space.

If one follows the carry trade for too many months, however, it can end in tears, Dueker says, especially if the high-interest currency rises well above long-run fair value.

Such a sharp reversal in currency values is possible in 2012 because high-interest currencies, such as the yen, euro, Australian dollar and Canadian dollar, appear to be above long-run fair value at the current exchange rate. Furthermore, there are possible triggers for those currencies to depreciate, such as heightened turmoil in peripheral European countries, especially the latest scares related to Greece, with shaky Ireland, Portugal and Spain. As for Australia and Canada, a sudden reversal in commodity prices could cause those currencies to swing sharply lower.

And so here’s a possible timeline for Federal Reserve policy steps for the rest of this year and 2012, according to Russell’s Dueker:

• Year-end 2011 — The Fed stops reinvesting proceeds from coupon payments and maturing securities — proceeds that rack up to $20 to $30 billion a month,

• End of first-quarter 2012 — The Fed initiates reverse repurchase sales of securities as the three-month yield rises above 0.25 — the rate the Fed pays banks on excess reserves,

• Second policy meeting in 2012 — The Fed drops the “extended period” language,

• August 2012 — The first Fed rate hike takes place when Fed balance sheet is around $2 trillion,

• Remainder of 2012 — Fed rate hikes proceed, keeping in mind that 1994 was ‘too hot’ and 2004 was “too cold.”

“The view within the Fed when they raised interest rates in 1994 was that the economy was running too hot and the brakes needed to be applied. In 2004, the Fed’s tightening process was too cool, with only 25 basis point hikes,” Dueker says.

He also suggests that the Fed will not make asset purchases after June 30 and doesn’t see a Quantitative Easing 3 but likely a continuation with a slightly different tactic. “QE3 will not be necessary if the Fed is very slow in its interest rate hikes.”

Eyes are on other central banks, which will move even if the Fed doesn’t, leading to an interest rate differential, holding the dollar down. Commodity prices are affected, too, and raise such questions as: Will the Canadian and Australian dollars stay or go lower if the Fed intervenes? And what of the Europe debt crisis — these risks are out there and may work against stability.

“Institutional investors are more deliberate about currency exposure, thinking carefully about whether or not they want that risk,” says Bob Collie, Russell Investments’ chief research strategist, Americas Institutional. “It’s relatively easy to manage currency exposure separately; potentially dependent on whether or not you think there will be a weakening of the dollar.”

Want to buy British or Japanese stock? You have to take currencies into consideration. Currency forwards are the best way to go about managing these exposures.

“The majority of institutional investors don’t typically deal with more than five currencies,” Collie says. Rather than playing around with minor currencies, they tend to focus on the majors where the bulk of their exposures are because of liquidity — they are the cheapest to trade, and the most transparent. Foreign exchange markets are enormous and very well developed.”

Douglas Borthwick, a managing director for trading at Faros Trading LLC in Stamford, Conn., which executes foreign-exchange transactions for institutional investors, points to the recent manufacturing numbers, which are grinding to a halt. “And indeed are now reversing: housing, employment and now manufacturing are slowing considerably as the Fed punch bowl of quantitative easing (QE2) is about to be removed.”

Borthwick opines that it’s very likely that the Fed will not raise rates through 2011, and will do all it can to keep interest rates low through 2012. “The sugar high is wearing off and the U.S. economy is finding itself back where it began the QE2 cycle, with the only tool left in the toolbox being a weaker U.S. dollar in order to inflate the economy out of this depression.”

The weaker U.S. dollar is not a passing phase, he says, but rather a longer-term phenomenon. “Our belief is that the U.S. Federal Reserve has no options left but to weaken the U.S. dollar in order to grow exports and make U.S. workers more competitive in the global arena.”

But to Borthwick, a slowing economy, evaporating confidence and anemic housing will dissuade Fed hawks from raising rates, and once again bring forward the prospect of continued quantitative easing, QE3, at the end of the summer. With this backdrop, the U.S. dollar will continue to weaken against its peers.