Dollar Carry Not Yen Carry - The Most Important Trade of 2010

"You can avoid reality, but you cannot avoid the consequences of avoiding reality".

Ayn Rand (1905-1982)

In the midst of a sudden burst of volatility across a number of asset classes over the last four weeks, one is reminded of comments made back in January 2010 by the Deputy Governor of the Bank of China.

He said, in what may be fast becoming a trading reality for a number of hedge funds, prop shops and SWFs, that the biggest risk to the global financial system was the unwinding of a dollar carry trade.

The scale of this unwind (rumored to be in the order of $1,500 billion) would manifest itself in a sell-off in so-called risky assets like emerging market currencies, equities as well as commodities (like copper) and more recently the euro and yen. The fundamental basis for this unwind purports that the U.S. would lead a global tightening in interest rates and that this would turn the U.S. currency into an investment as opposed to a funding currency.

The problem with this thesis is that the Federal Reserve has stated that the Fed Funds rate will remain low for an extended period. In the meantime, other central banks have tightened, namely: China, India and the RBA. So what we have now have is the dollar being bid-up as a safe haven in the face of geopolitical and sovereign debt risks with investors again being sucked into the U.S. Treasuries as the only "riskless asset in town".

However you cut it, the U.S. dollar is likely to continue its medium term assault higher sucking in global portfolio flows away from potentially more attractive NPV projects in the BRICs and emerging markets in general. Confirming this, recent Treasury statistics for March 2010 showed that overseas investors (including the Chinese) have increased their appetite for U.S. stocks and bonds by a combined $140 billion. This was a massive $93.4 billion over February. The bulk of these flows have headed to "riskless" U.S. Treasuries, to a lesser extent stocks and even back to illiquid U.S. real estate projects.

In the long run though, a shortage of available global riskless assets is a BIG weakness in the global financial system, and may warn that the market turnaround in rates will make the inevitable outflows all the more vicious and destablizing.

With trends now clear and present across a number of asset classes expect macro, multi-strategy funds and managed futures hedge funds to enjoy a period of solid, albeit volatile returns, while the outlook for long/short equity managers may be a little more difficult as equities zig-zag lower as the global "w-shaped recovery" takes shape and sluggish growth and persistently high unemployment takes root.

A supplementary point to the above observation, is that the U.S. Treasury bond market which is benefiting greatly from the current rush of safe-haven capital, is likely to snap higher once the deteriorating state of the fundamentals take shape. Maybe the dollar moving higher will choke off some of the market share that large U.S. multi-nationals had been making recently in overseas markets, including in Asia. It is all worth watching with volatile, bated breath. Mahalo.