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Dollar Will Be New Carry Trade Darling

By    |   Thursday, 25 Jun 2009 11:23 AM

The U.S. dollar has the makings of the next funding currency for the carry trade.

A carry trade is when you sell a lower-yielding currency and buy a higher-yielding one. You earn the difference between the two currencies daily, seven days a week.

This type of currency investing strategy works great as long as the currency that you are selling mostly trades sideways or heads lower. At the same time, you want the higher-yielding currency to be stable-to-rising.

For the past two years, it's been the low-yielding currencies that have risen and the higher yielding ones that have fallen. So, the carry trade has been out of favor for a year or two.

However, the trade is coming back because stabilization in the financial markets is returning.

Stocks and currencies alike may not head higher as quickly as they did in previous bull markets, even though they are recovering now. Previous recessions weren't as long and as deep as this one has been.

The average recession lasts between nine to 12 months, and this one will likely be closer to two years by the time it's over.

However, the nice thing about the carry trade is that it doesn't matter if currencies come roaring back quickly because you're earning interest daily while you wait for the appreciation of the currency over time.

Compare this to stocks and at best you can count on interest quarterly, and that's if the stock pays interest at all.

So here's why the dollar will be the currency on the "sell side" of the carry trade while other foreign currencies like the Aussie and New Zealand dollars will be on the "buy side" of the carry trade.

First, the reasons why the dollar will be on the sell side of this equation.

For starters, interest rates will not begin to be raised in the United States nearly as quickly as investors think. In fact, the Fed is trying to put out that fire right now by considering mentioning in their interest rate statement this week that they plan to keep rates low for quite a while, likely on into 2010.

Other central banks have done this recently and it's served them well. This way they've set expectations properly so that traders don't just buy up their currency due to the thought of coming interest rate hikes anytime soon.

Next, Obama's policies won't provide stability for the dollar or U.S. stocks in comparison to the confidence that you will find in foreign currencies and stocks. Obama acts like he's helping the public by stiffening regulations, increasing taxes, threatening to take over financial institutions like banks that could fail and have the ability to go in and fire their CEOs on the spot.

This is not conducive to capitalism. It doesn't encourage talent to stay here. What Obama doesn't realize is that talent and capital and even companies for that matter, are mobile. They can be moved to other countries that are more favorable for them to reside in.

Obama is not instilling confidence in the dollar by these actions and he won't be changing his stripes any time soon. So that's one more long term weight on the dollar.

Third, another weight that was mounting before Obama got into office and is mushrooming as he is just getting started as president is the mounting U.S. debt. Just the thought of this huge debt is causing other countries to formulate new ways to do trade outside of the dollar and how to invest in other things than U.S. Treasuries. They'll still invest in them, just not as strongly as they did before.

Even now, China is investing in commodities like iron ore. Brazil and Russia are investing in IMF bonds. China, Brazil, and Russia are all working on ways to trade in rubles or yuan and not as much in dollars as they did before. This really hasn't ever happened before to this extent.

This brings me to my fourth point.

U.S. Treasuries are being sold off as a result of all of the worries from the previous three points I discussed. The sell-off in Treasuries is enough to scare away some money because as foreigners invest in Treasuries, they are losing money both on the Treasury itself and also on the dollars that they are denominated in. So, when they sell their foreign currency and buy (exchange into) dollars and then use them to purchase Treasuries, they get a double loss as they lose both ways.

Point No. 5: There are simply more enticing places for investors to place their money now.

The emerging markets have been on fire lately. Brazil, Russia, India, and China (BRIC) have all been recovering much more quickly than the United States in both their stocks and their currencies. Therefore, someone in the United States who chooses to invest in their markets lately, have been winning on the currency conversion and also on the stock gains, too.

This trend will continue. While I wouldn't invest in Russia personally, the others are great choices especially when compared to the United States.

Now to the final point why the dollar will fall and make a good currency to sell in the carry trade: The excessive printing of money coupled with the recovering economy will drive up commodities once again. As this happens, that will aid the dollar in its fall.

So the dollar becomes a prime candidate for the "sell currency" in the carry trade, especially vs. the Aussie dollar.

For all of these reasons, the dollar is poised to fall against most other major currencies out there in the coming year or so.

Therefore, you will especially see the U.S. dollar fall against the Aussie dollar which will do well as the Australian economy has fared so much better.

Australia will also be a direct beneficiary of the rise in commodities as it works against the dollar at the same time. Therefore, the buyers of the AUD/USD pair should bode well over the next year or two as the dollar continues to crash and burn.

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SeanHyman
The U.S. dollar has the makings of the next funding currency for the carry trade. A carry trade is when you sell a lower-yielding currency and buy a higher-yielding one. You earn the difference between the two currencies daily, seven days a week. This type of currency...
dollar
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2009-23-25
Thursday, 25 Jun 2009 11:23 AM
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