Another negative for the dollar: it is starting to displace the yen as the funding currency for the carry trade.
As most readers probably know, the carry trade is when one borrows in one market that offers low borrowing costs and invest in one with high yields. It is easy money, but comes with the large risk that prices in the funding market will move against him, offesetting or even exceeding the profits on the interest spread.
Historically, the yen was the favored market for borrowing, but, as this Bloomberg story reports, the dollar is becoming increasingly popular. And when you fund in one currency to invest in another, you sell the borrowed currency. Done on a large enough scale, as it was in Japan, the carry trade depresses the price of the funding currency.
Since the cost of borrowing in dollars at 4% is still relatively high for this sort of operation, it suggests that dealers are confident that the dollar will continue to depreciate. Nevertheless, the Bloomberg story also quoted some dollar bulls.
Using the dollar to pay for purchases of currencies with higher yields is proving to be the most profitable trade in the foreign-exchange market.
A basket of currencies including the British pound, Brazilian real and Hungarian forint financed with dollars returned 17 percent this year, compared with 9 percent when funded in yen and 7 percent in Swiss francs, according to data compiled by Bloomberg. Falling U.S. interest rates and increasing volatility in the yen and franc are making the trade even more appealing.
“With the dollar giving the appearance of being in free fall, it increases the attractiveness of using the currency to fund investments,” said Avinash Persaud, chairman of London- based Intelligence Capital Ltd., which advises hedge funds that manage more than $89 billion. “That process will only add more fuel to the decline.”
The last time the U.S. currency was used for so-called carry trades was in 2004, when the Federal Reserve’s target rate for overnight loans between banks was 1 percent, said Niels From, a strategist at Dresdner Kleinwort in Frankfurt. Since then, it has weakened 18 percent on a trade-weighted basis, according to a Fed index….
Investors may switch more than $100 billion of borrowing from yen or francs into dollars in the next two years for carry trades said Jens Nordvig, a strategist with New York-based Goldman Sachs Group Inc., the biggest U.S. securities firm by market value.
The value of futures contracts held this month by hedge funds and traders betting against the dollar was a record $33.9 billion more than contracts that profit from a gain, according to New York-based Morgan Stanley, the second-biggest U.S. securities firm.
Pacific Investment Management Co., which oversees the world’s biggest managed bond fund, is selling dollars against the Brazil real, Mexican peso, Korean won and Singapore dollar.
“When we think about currencies on a three- to five-year basis we’re very bullish on emerging markets versus the U.S. dollar,” said Andrew Balls, who helps manage $80 billion for Newport, California-based Pimco. “That view is only reinforced when you look at interest-rate differentials.”
The real rose 18.5 percent this year and Singapore’s currency strengthened 6.4 percent, while the won was little changed. The Mexican peso fell 1.4 percent, the only one of the 16 most-traded currencies to do worse in the foreign exchange market.
Pimco, a unit of Munich-based insurer Allianz SE, expects the Fed to lower borrowing costs to around 3 percent, from 4.5 percent. Policy makers have reduced the rate by 0.75 percentage point since Sept. 18.
Interest-rate futures on the Chicago Board of Trade show investors see a 58 percent probability that the U.S. benchmark will drop to 3.75 percent by March 31. Switzerland’s key rate is 2.75 percent and Japan’s is 0.5 percent.
The dollar produced a positive carry, the combined gain from the difference between interest rates and changes in foreign exchange, against 20 of the 24 most actively traded emerging market currencies this year, Bloomberg data show. The franc was positive against 12 and the yen versus 14….
Strategists say the U.S. currency will recover because the economy is adding jobs and producing faster inflation, limiting the Fed from reducing borrowing costs. The dollar will rebound to $1.42 per euro and to 113 yen by the end of June, according to the median forecast of 41 analysts surveyed by Bloomberg….
“The dollar becomes a safer source of funding” as volatility rises, said Maxime Tessier, head of foreign exchange in Montreal at Caisse de Depot et Placement, which manages $151 billion.