The Carry Trade

[DantesPeak]

The Fed is only a minor palyer in the last two years in the creation of fiat money, which explains why this carry trade money is available in the first place.

Part of the reason that the world economic structure can support higher rates of inflation (mostly energy inflation) is that other countries are creating money out of thin air to buy dollars. In 2004, this was Japan. In 2005, it is China.

In the first quarter of 2004 only, the Japanese created $100 billion in paper (fiat) money. That is where the money mostly used in the carry trade described above came from. However since then, the Japanese have been much more conservative about this policy.

I estimate that China was creating new money at a rate of $150 billion per year in the first half of 2005. The Chinese revaluation was partly motivated to move away from the very inflationary policy of creating money to buy US dollars (coming to China as part of the trade surplus).

[MonteQuest]

The Fed is only a minor palyer in the last two years in the creation of fiat money, which explains why this carry trade money is available in the first place.

Part of the reason that the world economic structure can support higher rates of inflation (mostly energy inflation) is that other countries are creating money out of thin air to buy dollars. In 2004, this was Japan. In 2005, it is China.

In the first quarter of 2004 only, the Japanese created $100 billion in paper (fiat) money. That is where the money mostly used in the carry trade described above came from. However since then, the Japanese have been much more conservative about this policy.

I estimate that China was creating new money at a rate of $150 billion per year in the first half of 2005. The Chinese revaluation was partly motivated to move away from the very inflationary policy of creating money to buy US dollars (coming to China as part of the trade surplus).

Yes, with the renimbi pegged to the dollar, as we inflated, so did they. Perhaps they are seeing that our monetizing will reek havoc with their economic plans, so it is time to cut the cord.

[CARVER]

The article was from a year ago. Some quotes:

Many have forgotten what can happen to the equity markets when the Fed embarks on a rate raising cycle. The last time this happened in June of 1999, it took only a 1.75 percentage point increase in the Fed funds rate to bring about a stock market collapse and a recession. Yet, Wall Street repeats the mantra that as long as the Fed rate hikes are gradual, the party will continue. Nothing could be further from the truth. Nearly all rate raising cycles end in financial and economic mishaps. When the Fed begins raising rates, bad things happen to the financial markets and the economy. It won’t be any different this time. The only difference will be that it will take fewer rate hikes to send the markets and the economy into a downward spiral.

Unlike the U.S. in the 1930s and Japan in the 1990s, the U.S. is no longer a creditor nation. It has become the world’s largest debtor. The inflation consequences of debtor nations are much different than creditor nations. Debtor nations are more apt to suffer the inflationary consequences of their credit inflations.

This is very disturbing. Some say we get deflation others say we get hyperinflation, either way it is going to be very bad.

[jimmydean]

Guys as a side newbie question what protections are there against other nation governments simply printing currency and buying $USD? With China's huge trade surplus printing a few more $billion Yuan and using it to buy treasuries would go almost unnoticed? By doing so they devalue their own currency but due to fixed conversion rates on the Yuan they are still laughing?

I saw a related item on MSNBC. Essentially this economist was discussing the near term problem we are facing as mortgage rates increase over the next year there will be some people that cannot afford them (they are at capacity) and others that will drastically drop discretionary spending to continue paying their mortgages.

Either of those situations means we are in for a helluva ride the next year or so.

[MicroHydro]

PIRATES OF THE CARIBBEAN

Link

I remember that story, and agree with the author.

Ever since I saw theCFM56 (737 engine) that fell off the plane that hit the WTC south tower (supposed to be UA flight 175, a widebody 767) and landed at the corner of Church and Murray, I have known that the US government is now capable of any crime imaginable. Congress and the media are bought and paid for shills that enable the rampant criminality. Perhaps now the gangsters at the Fed are so bold they no longer see any need to hide the monetization of the debt. Joe and Jane consumer don't care as long as their home value keeps rising

[DantesPeak]

Guys as a side newbie question what protections are there against other nation governments simply printing currency and buying $USD? With China's huge trade surplus printing a few more $billion Yuan and using it to buy treasuries would go almost unnoticed? By doing so they devalue their own currency but due to fixed conversion rates on the Yuan they are still laughing?

Actually, since the IMF system under which all countries participate, actually forbids a linking of a currency to a set good - such as gold - there is no formal restriction on the printing of fiat money.

There are informal restrictions, such as market forces and awareness, and sometimes, like the US just requested from China, it asks other countries to adjust their currency or monetary policy. The G-7 meetings are one important way to synchronize policies.

[MonteQuest]

Guys as a side newbie question what protections are there against other nation governments simply printing currency and buying $USD? With China's huge trade surplus printing a few more $billion Yuan and using it to buy treasuries would go almost unnoticed? By doing so they devalue their own currency but due to fixed conversion rates on the Yuan they are still laughing?

The only thing that allows us to inflate our money supply like we do is the dollar hegemony. We are the world's reserve currency.

Imagine this: You are deep in debt and have very little money in the bank. But every day you write a check to cover your expenses. Your checks are worthless but they keep buying stuff because those checks you write never reach the bank. You have an agreement with the oil merchants (OPEC) that they will accept only your checks as payment for one thing everyone wants, and must have—oil.

This means everyone must hoard your checks so they can buy the oil they need. Since they have to keep a stock of your checks, they use them to buy other stuff too. You write a check to buy a TV, the TV shop owner swaps your check for oil, that seller buys some vegetables at the fruit shop, the produce man passes it on to buy bread, the baker buys some flour with it, and on it goes, round and round—but never back to the bank where it would bounce. You have generated a huge debt on your books, but so long as your checks never reach the bank, you don't have to pay. In effect, you have received your TV for free!

This is the position the U.S.A. has enjoyed for 30 years—it has been getting a free world trade ride for all that time. It has been receiving a huge subsidy from everyone else in the world. And as our debt grew, we printed more dollars (wrote more checks) to keep trading.

Pretty slick deal, eh? Any questions as why we didn't want Iraq to sell their oil in euros? Or why the Iranian oil bourse coming soon is a bug up the US's arse?

[jimmydean]

The only thing that allows us to inflate our money supply like we do is the dollar hegemony. We are the world's reserve currency.

Imagine this: You are deep in debt and have very little money in the bank. But every day you write a check to cover your expenses. Your checks are worthless but they keep buying stuff because those checks you write never reach the bank. You have an agreement with the oil merchants (OPEC) that they will accept only your checks as payment for one thing everyone wants, and must have—oil.

This means everyone must hoard your checks so they can buy the oil they need. Since they have to keep a stock of your checks, they use them to buy other stuff too. You write a check to buy a TV, the TV shop owner swaps your check for oil, that seller buys some vegetables at the fruit shop, the produce man passes it on to buy bread, the baker buys some flour with it, and on it goes, round and round—but never back to the bank where it would bounce. You have generated a huge debt on your books, but so long as your checks never reach the bank, you don't have to pay. In effect, you have received your TV for free!

This is the position the U.S.A. has enjoyed for 30 years—it has been getting a free world trade ride for all that time. It has been receiving a huge subsidy from everyone else in the world. And as our debt grew, we printed more dollars (wrote more checks) to keep trading.

Pretty slick deal, eh? Any questions as why we didn't want Iraq to sell their oil in euros? Or why the Iranian oil bourse coming soon is a bug up the US's arse?

In effect we are IOU'ing everything. The sorcery of FED print, foreigners buying our debt (belief in repay/security), individuals financing/spending beyond income levels (belief that income will improve) is keeping this cycle going.

I wonder if the FED has masterminded this (for a plan yet unseen) OR the foreign powers are gaining control since we owe them so much. As stated on other threads if foreigners start redeeming our debt the economy is going to fall apart (cycle ends). We are left with a crippled economy while foreign nations are left with real assets, cheap labour and can still continue in some form.

So what prevents the Chinese government from printing Yuan and buying treasuries further increasing our liability, short-term keeping their currency low but long-term they have a lever against us?

[neo]

Ah, you missed the point of this thread altogether. The carry trade. You can borrow short term from Japan at almost zero interest and buy long-term bonds in the US at 4.18%. Pocket the difference.

I heard somebody did this in 90s and made millions of dollars. US interest was like 7-8% back then while the Japanese had 1% interest for loan. It's like a sure bet; I wonder why not everybody is doing that.

[CARVER]

The European Central Bank (ECB) has the following objective:

The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.

For this they have agreed that money creation should never exceed 4,5%. And even this 4,5% is only allowed when the economy grows at a rate of (at least) 3%. However to fight off a recession the creation of money has been on an average of 7% a year over the last couple of years. Last month it was even 7.9%, while the economy grows only like 1% (on average). Yet in the same years the inflation/CPI figures have averaged below the 2%, so it seems they have achieved their primary objective, but we know how these figures are manipulated. We are also being encouraged to take low interest loans and spend money to kick-start the economy. We also have a housing bubble (and a stock market bubble). It does not appear to be doing the trick, it's just delaying the inevitable (that is what it looks like to me).

It does not seem to me that the EU is doing a lot better than the US. When the USD tanks the EURO might not be far behind, what do you think?

[MrBean]

The European Central Bank (ECB) has the following objective:

The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.

For this they have agreed that money creation should never exceed 4,5%. And even this 4,5% is only allowed when the economy grows at a rate of (at least) 3%. However to fight off a recession the creation of money has been on an average of 7% a year over the last couple of years. Last month it was even 7.9%, while the economy grows only like 1% (on average). Yet in the same years the inflation/CPI figures have averaged below the 2%, so it seems they have achieved their primary objective, but we know how these figures are manipulated. We are also being encouraged to take low interest loans and spend money to kick-start the economy. We also have a housing bubble (and a stock market bubble). It does not appear to be doing the trick, it's just delaying the inevitable (that is what it looks like to me).

It does not seem to me that the EU is doing a lot better than the US. When the USD tanks the EURO might not be far behind, what do you think?

Hard to say, the magnitude of the problem is not even close to US as there's no petroeuro recycling, Eurozone has very strong export sector and debt situation is not as alarming.

Would be interesting know how euro-inflation is calculated, is it manipulated as badly as US CPI? There certainly is lot of inflation felt after the switch from national currencies to euro.

[MonteQuest]

Alan has spoken...don't count your chickens just yet.

On Bloomberg today:
Greenspan Says Fed Paying Attention to Asset Prices

``Such an increase in market value is too often viewed by market participants as structural and permanent,'' Greenspan, who is scheduled to retire as Fed chairman in January, said. ``History has not dealt kindly with the aftermath of protracted periods of low risk premiums.''

Translation: Don't count on your house always going up in value.

``We have a housing valuation issue,'' said Kurt Karl, chief U.S. economist at Swiss Reinsurance in New York, in an interview. ``The time is now for raising interest rates and defusing these problems potentially by slowing down the economy a bit and avoiding a big necessary increase later and a consequential recession.''

Karl expects the Fed to raise the target rate to 4.5 percent, from the current 3.5 percent, by the middle of 2006 before stopping. ``There is a risk that they will go beyond 4.5 percent,'' he said.

I said 4.75 to 5.5% in my initial post.

Link

[MonteQuest]

In my initial post I stated:

If nothing “breaks”, and energy prices continue to fuel inflation, I think we can expect short-term rates in 2006 around 4.75 to 5.5%, or higher.

It is now 4%. Many economists are now predicting the Fed will bump up rates at its next session on Dec. 13, as well as on Jan. 31. Some analysts also are calling for a rate increase on March 28, which would be the first presided over by Helicopter Bernanke.

The 10-year bond is at 4.6%. So much for the Carry Trade. Greenspan and the Fed recognize that they created the carry trade. It was a consequence of their desire to stimulate the economy with lower rates. They also recognized the dangers of those trades unwinding quickly, forcing funds and traders to sell in order to meet minimum cash requirements.

The carry trade was so massive that the FED was afraid to raise short-term rates more than 25 basis points. We could now see 50 basis points raises to curb the inflation fears. The money supply has already been ramped up.

[actionreplay]

Why would anyone buy a 10 year note for a measly 4%? You can get 3.30% in a savings account right now and have access to the cash within 24 hours. They need to raise the rate to encourage savings and to force credit card addicts to cut back. Plus they need a better payback to continue to get the foreign investment money flowing into the system.

Ah, you missed the point of this thread altogether. The carry trade. You can borrow short term from Japan at almost zero interest and buy long-term bonds in the US at 4.18%. Pocket the difference.

I thought the standard finance theory on this type of arbitrage was that the exchange rate changes pretty quickly to neutralise such opportunities, as investors rush in to capitalise on this.

The short v. long term rate arb trade is interesting though. Haven't heard of this before. I guess you are saying when this source of free money for "sub-prime" lending (ie high-risk) dries up, that will be the end of "easy credit"?

[MonteQuest]

Why would anyone buy a 10 year note for a measly 4%? You can get 3.30% in a savings account right now and have access to the cash within 24 hours. They need to raise the rate to encourage savings and to force credit card addicts to cut back. Plus they need a better payback to continue to get the foreign investment money flowing into the system.

Ah, you missed the point of this thread altogether. The carry trade. You can borrow short term from Japan at almost zero interest and buy long-term bonds in the US at 4.18%. Pocket the difference.

I thought the standard finance theory on this type of arbitrage was that the exchange rate changes pretty quickly to neutralise such opportunities, as investors rush in to capitalise on this.

The short v. long term rate arb trade is interesting though. Haven't heard of this before. I guess you are saying when this source of free money for "sub-prime" lending (ie high-risk) dries up, that will be the end of "easy credit"?

The banks will no longer be able to profit from the carry trade, thus interest rates will rise to offset the loss in revenues. Also, the Fed will be more likely to be "restrictive" than "accomodating" and will raise the prime 50 basis points rather than 25.

So, yes, the easy credit days are numbered.

[frankthetank]

I was just talking to my brother who refinanced his house (into a fixed rate) @ 4.875 a few months ago. Looks like he might as well pay minimum payments and stick the rest in a money market (the highest currently being 4.1, but should rise more)...

[cube]

Ah, you missed the point of this thread altogether. The carry trade. You can borrow short term from Japan at almost zero interest and buy long-term bonds in the US at 4.18%. Pocket the difference.

I heard somebody did this in 90s and made millions of dollars. US interest was like 7-8% back then while the Japanese had 1% interest for loan. It's like a sure bet; I wonder why not everybody is doing that.

Q: I wonder why not everybody is doing that.

A: When viewed in hindsight it always looks so obvious and easy.

What's the old saying? "Anyone can call all the shots of monday night footbal on a tuesday night."

[actionreplay]

Ah, you missed the point of this thread altogether. The carry trade. You can borrow short term from Japan at almost zero interest and buy long-term bonds in the US at 4.18%. Pocket the difference.

I heard somebody did this in 90s and made millions of dollars. US interest was like 7-8% back then while the Japanese had 1% interest for loan. It's like a sure bet; I wonder why not everybody is doing that.

Q: I wonder why not everybody is doing that.

A: When viewed in hindsight it always looks so obvious and easy.

What's the old saying? "Anyone can call all the shots of monday night footbal on a tuesday night."

Actually this is the textbook theory of FX rate fluctuation - changes in FX are caused by differences in interest rates. Once someone notices the above, they buy that currency, pushing up the demand, and hence the price. if you get there first you get the money, but there are plenty of pro FX dealers who make their money doing this - exploiting currency/interest rate arbitrage opportunities...

However, they may have been other reasons at the time why this didn't happen at the time discussed above (I believe that keeping yen deposits with Japanes banks, for example, actually cost money - ie they charged you interest - due to the deflation, for example), but usually in that case there are good reasons to be careful!

[MrBill]

The carry trade only works when

a ) you take on interest-rate gap risk (i.e. borrow short & lend long)
b ) you take on credit risk (i.e. interbank borrowing & lending to corporates)
c ) you take on FX risk (i.e. borrow in yen & lend in dollars)

What may look like a risk free trade to you can be fraught with risk, especially if many others are attempting this arbitrage at the same time. For example, borrowing USD at low interest rates and investing in high growth Asia (the Asian currency crisis in 1996/97; borrowing in USD and investing in high yield local currency markets (the Russian currency crisis in 1998); or borrowing in USD and investing in low grade debt (i.e. the Argentine default in 2001).

Many companies lost money when they borrowed in yen because the interest rate was lower than in dollars, but then they had to repay back stronger yen with depreciated dollars. The dollar has lost 40% of its value against a basket of currencies since 1987 (yen, Sterling, Swiss franc and the legacy currencies of the euro).

One inadvertent affect of the cheap interest policy of the US and the carry trade is that many traders borrowed USD to invest in emerging markets and then sub-investment grade corporate debt markets (i.e. junk bonds) As yields decreased investors took on more leverage and invested in risky assets classes, but drove down yields in these markets as well,
and now we are seeing those trades come undone as traders rebalance their portfolios.

But, by the way, I do not see how this is a Peak Oil discussion? Most of the points made are not even accurate (links or no links if they are not from reliable sources). I read a lot of conspiracy theories. A lot of conjecture. Most of the comments demonstrate a lack of knowlege of capital markets & finance. Therefore they are of no value in planning for a post-Peak Oil economy IMHO?

[MonteQuest]

But, by the way, I do not see how this is a Peak Oil discussion?

Tied to it in my initial post:

If nothing “breaks”, and energy prices continue to fuel inflation, I think we can expect short-term rates in 2006 around 4.75 to 5.5%, or higher.

The forum is for discussion related to the economics ramifications of hydrocarbon depletion. And if rising energy costs fueling inflation is not a ramification, I don't know what is.

It is what peakoil is all about. This is a precursor.