Goldman On The Dollar Carry Trade: "A 20% Reversal In Either 3 Months Or 3 Days"
As the decoupling between cause and effect continues: i.e., the economy and the stock market, more and more pundits focus on the dollar carry trade as the primary culprit for market appreciation. With the US market flat for the year when indexed for the decline in the dollar, the entire rally has been one big window dressing to prop up Obama's confidence boosting propaganda. Yet the entire rally, aside from the unique technical peculiarities underpinning it (short squeeze, low volume/high momentum algo participation) has been carried on the back of the dollar's decline: take away the concept of importing inflation at all costs (which is what Bernanke is happy to continue doing) and US deflation would have been rampant by now, proving the Fed's plan to liquefy the capital markets to be a disaster. As such, the only thing that allows the "rally" to continue, is the willingness of the Rest of the World to fund not only the skyrocketing US budget deficit, but the Chinese trade imbalance, courtesy of the yuan-dollar peg.
The rally will come to an abrupt end when one of two things happens: i) the Fed gives an indication it wants investors to stop chasing risky assets (likely not for at least 5 years) and ii) the rest of the world realizes that America has no leverage whatsoever, with its crumbling economy, and its loose monetary policy which as prominent Chinese figures have already determined, is currently causing asset bubbles worldwide (yet which the Chairman is unable to see). Possibility ii has a much greater probability of occurring, yet if and when it does, will be dependent in great extent on the future of the dollar carry trade.
Nouriel Roubini has already pointed out the great danger posed by every single trader in the world being short the dollar. As we saw on Monday, one word out of place by Bernanke, and the reversal will be disastrous. Below we present the thoughts from Goldman Sachs, which, as expected, is much more sanguine about the impact and the participation in the carry trade. To Goldman, the dollar value is merely a function of the US economy's weakness. Ironically, Goldman has been pumping up the strong economy story for much of H2, until recently when even 85 Broad has reversed its opinion. While Goldman's observations are not surprising, the question emerges as to how the firm is positioned now to make the higher amount of money from a macro picture, as very few trade on company-specific alpha: courtesy of banks like Goldman, every asset class has become one big beta bucket.
If Goldman is wrong, which it likely is in this case, the impact would be rapid and dramatic: as Goldman itself notes: a 20% reversal which would come in either 3 months or 3 days. Let's recall Goldman's stance on oil last summer to see just how spectacularly wrong the world's most riskless hedge fund can be in its "policy" guidelines.
Factors Driving Dollar Weakness besides Dollar-Funded Carry Trades
There has been a lot of focus recently on the extent of Dollar-funded carry trades contributing to the decline in the USD. The IMF in a report prepared for the recently concluded G-20 Finance minister’s meeting cited ‘In addition to foreign funds moving into emerging market equities, led by expectations of higher growth, there are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the Euro and some emerging economy currencies.’ We find the argument of Euro benefiting from this particular dynamic somewhat challenging though, given the minute rate differentials here. But overall, there are carry trades funded in USD and other commentators have expressed their worries over a new ‘carry bubble’ emerging. While pinning down precisely the extent to which speculative Dollar funded carry trades are taking place is not an easy task, we can point to a few other factors behind Dollar weakness so far this year. Simply put, the Dollar's decline so far does not seem too out of line, especially when you consider that the US is still cyclically one of the weakest economies around.
While there has been a pick-up in investment in higher yielding currencies and assets, there is a distinction to be made between speculative carry trades and investments made on the basis of stronger EM fundamentals. It is hard to draw the line where investment activity becomes a speculative bubble but we do not think that we are in the midst of a 'carry bubble' at the moment. Yes, inflows into EM assets have accelerated rapidly over the last several months but this has also arguably been led by improving fundamentals in these countries in general. US equity fund flows into EM markets have broadly tracked the widening growth gap between EM countries and the US. We use a simple measure of real GDP growth in EM countries minus US growth to track the latter, which shows that the EM-US growth differential had peaked in 3Q of 2008, bottomed in 1Q 2009 and has since widened out again over the last 2 quarters . Plotting this EM-US GDP differential versus US equity fund inflows into EMs, there does not seem to be any significant divergence. The point being that EM equity flows so far have been underpinned to a certain extent by relatively stronger recovery prospects.
Other factors underpinning Dollar weakness include hedging asymmetries. We have most recently discussed this in our latest November FX monthly publication. In a nutshell, this refers to the likelihood that overseas investors in US assets appear to be FX hedged to a greater degree than US investors of foreign assets. As a result, a rally in risky assets tends to result in Dollar selling to maintain hedge ratios.
Finally, part of the Dollar weakness trend observed so far since the crisis has also been due to the ongoing normalization in markets. This has been well described in a recent speech by Chairman Bernanke: ‘When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains.’ Indeed, our GS USD broad TWI has retraced to a large extent but even now is still slightly stronger than the levels of autumn last year.
USD-funded Carry Bubble vs Bubbles from Importing US Monetary Policy
Thus while there are Dollar-funded carry trades and certainly other cyclical factors behind the Dollar’s weakness, we do not think we are seeing a speculative ‘carry bubble’ for now. The difference being a 20% strengthening in the Dollar upon a reversal, over say 3 months as opposed to 3 days for the latter.
There is also a difference between a Dollar-funded carry bubble and asset price bubbles from importing loose US monetary policy. There is certainly a case to be made of certain parts of the world currently experiencing rapid asset price inflation, as a consequence of the accommodative monetary policy of the US. Hong Kong comes to mind, importing the low US interest rate policy with its currency peg, despite having a different economic backdrop and real exchange rate appreciation pressures. Domestic asset price inflation is thus one of the release valves in such an instance, while maintaining an undervalued nominal currency. Same goes for Singapore with its managed exchange rate basket and imported low nominal interest rates. But this is largely a consequence of the adopted exchange rate regimes of these countries, where one way to ease asset price inflation would be to allow more domestic nominal currency appreciation.