Historical Dollar-Carry Perspectives
Recently the dollar has become the carry currency of choice for virtually anyone who breathes, let alone manages even one dollar in assets, courtesy of unprecedented Wall Street-Fed complicity. And while there is no longer any speculation about the carry trade's prevalence, it is interesting to observe how the topic of DXY-SPX -1:1 correlation has developed over the past two years. While digging through the annals of the Internet, we came across this essay by Brad Setser, in which the current Administration think-tanker is proven not exactly correct: "In my view, it will be hard for the dollar to emerge as major funding currency." Right.
Setzer's complete thoughts below:
Dollar, funding currency for the global carry trade?
With the Fed now aggressively cutting US interest rates to keep the
bursting of a real estate bubble from devastating the US financial
system and economy, is the dollar about to turn into the yen- that is,
the key funding currency for the global carry trade?
Mark Gongloff of the Wall Street Journal — citing a set of currency traders — posed the question yesterday:
Japan’s yen has been the carry-trade vehicle of choice for
years, given the country’s superlow interest rates. The Swiss franc has
been another. If the Fed keeps cutting rates, carry-traders might line
up to ride the dollar like a birthday pony, with important implications
for markets and the economy.
In my view, it will be hard for the dollar to emerge as major
funding currency. At least not in the absence of truly unprecedented
generosity from the world’s central banks.
Fundamentally, because the US has a huge external deficit and needs
to borrow money from the rest of the world even in a slump, while
Japan’s slump added to Japan’s external surplus and thus the supply of
funds it could lend to the world.
Funding currencies usually have — in addition to low interest rates
– lots of savings, and consequently spare funds to invest globally.
That doesn’t sound much like the US.
The United States own need for funding limits the dollar’s ability
to serve as a global funding currency.The US saves far less than it
invests, and has to make up the difference by borrowing from the rest
of the world. That is a constraint on the United States’ capacity to
supply dollars to investors who want to sell (borrowed) dollars to buy
higher yielding currencies.
Or, to put it a bit differently, the only way the US dollar can be a
funding currency in a deep macroeconomic sense is if more funds are
coming to the US – even with lower interest rates in the US than in the
rest of the world — than are needed to finance the US current account
deficit. Those investors borrowing dollars to invest outside the US
wouldn’t be borrowing US savings; they would be borrowing the rest of
the world’s savings that happens to be held in dollars.
And who might be the source of all those dollars?
Right now, there is only one realistic answer: the world’s central
banks. I rather doubt that they are willing to finance both the US
current account deficit and a large US dollar carry trade. [isn't it funny how Central Banks can pull pranks like that]
I have hardly been a cheerleader for sovereign wealth funds. In my
view, they raise at least as many problems as they solve: I would be
much more comfortable if sovereign investors stuck to index funds for
their equity exposure. But the whole point of sovereign wealth funds is
to avoid a world where private investors use dollar supplied by central
banks to fund lucrative investments outside the US. Sovereign funds
let governments make such investments on their own.
It is hard right now to say anything is impossible. Five years ago I
never would have guessed that the emerging world’s governments would
add over a trillion dollars to their external assets in a year, or that
the US government would tacitly encourage US banks to be recapitalized
by the investment funds of cash-rich (and less-than-democratic)
emerging market governments.
But a substantial US dollar carry trade would fly in the face of the
United States need to attract large sums of savings from the rest of
the world to "fund" its current account deficit.
That of course doesn’t mean that some US investors haven’t sold the
dollar to buy foreign assets, or that some foreign investors haven’t
borrowed in dollars to invest abroad. Recent market moves suggest that
"deleveraging" supports the dollar as well as the yen.
But there is an important difference between post-bubble Japan and
post-bubble America: Japan always ran a current account surplus and
never needed financing from the rest of the world.
As US rates fall, though, the US may find it hard to be attract
carry trade flows from places like Japan. The dollar may no longer be a
destination currency, even if it isn't quite a funding currency. The
absence of a yen/dollar interest rate differential has in the past
been associated with Japanese intervention in the currency market, as
the Japanese government picks up the slack from the carry trade.
Something to watch.
Hopefully Mr. Setzer, in providing macroeconomic advice to the Obama administration at Larry Summers' National Economic Council, is not too set in believing that the Fed can not surprise everyone and everything in what it ends up doing (without supervision).