As a postscript to my earlier post Never mind the quality, feel the funding, it is worth referencing an article by Nouriel Roubini in today’s FT. He calls the current situation the mother of all carry trades, since firms are borrowing in dollars to invest in risky assets, and implies that they have negative funding costs due to dollar depreciation. This isn’t strictly true as many of the assets are dollar denominated – unlike the yen carry trade from the 90s, there is not necessarily FX risk. But he is certainly right in suggesting that this bubble cannot stay inflated forever. Once solid US growth resumes, the FED will have to raise rates, and at that point the trade will become less attractive. Personally I don’t think that will happen until well into 2010, and if that is correct, we could have quite a large bubble by then…
Update. Further comment from FT alphaville is here. They comment on an interesting point – the increasing correlation of asset returns vs. the dollar. This quote from Olivier Jakob at Petromatrix explains the issue:
Equity analysts are saying that their markets are driven by the oil markets, oil analysts are saying that their markets are driven by the equity markets; everybody agrees on the Dollar correlation…
The level of speculative length in the oil commodities is extreme and these positions will require a further weakening of the Dollar Index to be sustained.
If oil is just another risky asset in this regard, then risk is accumulating in the system at a troubling rate. There is a way of getting cheap insurance though: buy cheap dollar calls vs. selling expensive oil calls.
I think China is all talk and no action on the dollar at the moment. But if they are not, there is a fortune to be lost or made when the Wile Coyote moment arrives.
Update from the Huffington Post here. My favourite quote is from Chalongphob Sussangkarn, a former Thai finance minister and now president of the Thailand Development Research Institute:
The U.S. deficit is so huge… This is why all countries, particularly [in] East Asia, are concerned because we hold a lot of these assets. What happens if the U.S. dollar falls 40 percent? Many central bankers will be losing huge amounts of money.
Suppose a bank buys an option written by a corporate. It ends up in the money. The bank hopes that the corporate will pay out.
But what if lots of other banks have bought the same type of option from lots of corporates. Very few of them hedged, and all the options are far in the money.
Now the banks have a systemic problem. Perhaps many of the corporates cannot afford to pay. In any case, their losses may be sufficient to cause government intervention. The banks may be caught in a storm of protectionism.
It seems, according to FT alphaville, that this is possible for the counterparties to Eastern European corporates on FX options. The corporates, in many cases I am sure with full understanding of the risks, sold zloty, koruna and forint downside as a Euro convergence play. All three of these currencies have fallen: the corporates have taken significant losses. And now, of course, the lawyers are getting involved.
The lesson, then, is that it is good to be right when selling options. Being a little bit wrong is bad. But if you are really really wrong, and lots of other people are too, that’s fine, because the government will probably bail you out.
A Bloomberg headline: Japan Economy Shrinks 12.7%, Steepest Drop Since 1974 Oil Shock. Now, I would have thought that that was bad for the yen. But no. Scroll down a couple of headlines and you find: Yen Rises as G-7 Says Slump to Persist. Wrong again.
The dollar December 18, 2008 at
A 4% return in 5 days? That will do me. The short dollar position is off. I still think it is a great long term trade idea and it will go a lot further, eventually, but I don’t want to push my luck.
The old version. Borrow in yen at low interest rates, convert in the spot market to dollars, buy dollar assets, and bet that the yen won’t strengthen so much that the dollar profits are wiped out by FX losses. It worked fairly well, on average, from 1995 to 2006 or so, partly due to structural weakness in Japan.
The new version. Borrow in dollars at low interest rates, convert in the spot market to high yield currencies like the Rand or Real, buy assets in those currencies, and bet that the dollar won’t strengthen so much the profits are wiped out by FX losses. It is working fairly well, on average, in 2007 due to structural weakness in the U.S., not least the newly found reluctance on the part of foreigners to buy U.S. securities.
What are you carrying today?
It was always going to take one more push to get the dollar into that Wile E. slide. Perhaps the news from Gisele was it? Here (from barchart.com via Calculated Risk) is the recent action on the U.S. dollar index Dec futures
I trust regular readers will be impressed by my restraint in not using the story about Ms. Bündchen to post a gratuitous picture of her. The tricky decision we now face is what to do first: call her to offer advice on FX hedging, or to attend to our own portfolios. Transaction or relationship people?
Update. Gisele and Ben in conversation at Long or Short Capital is worth reading.
The head of the IMF, Rodrigo Rato, is worried about a Wile E. Coyote moment for the dollar too. Speaking at a meeting in Washington he said:
There are risks that an abrupt fall in the dollar could either be triggered by, or itself trigger, a loss of confidence in dollar assets.
The uncertainty … comes from downside risks that are much higher than they were six months ago. The turbulence in the credit markets is a warning that we cannot take the benign (global) economic environment of recent years for granted
When the party ends, someone is often found passed out in the loo. It looks like it might well be good old USD’s turn for the thumping hangover this time.
From the Telegraph:
The Saigon Times said this morning that the State Bank of Vietnam was abandoning the attempt to hold down the Vietnamese currency through heavy purchases of dollars.
Separately, the gas-rich Gulf state of Qatar announced that it had cut the dollar holdings of its $50bn sovereign wealth fund from 99pc to 40pc, switching into investments in China, Japan, and emerging Asia.
This action is certainly adding pressure to the dollar and further falls seem likely. But will we see a rout (aka a Wile E. Coyote moment)? Put on your gamma, take a seat, watch the action.
Paul Krugman uses the term ‘Wile E. Coyote’ moment for when traders find a currency level is unsupported by fundamentals and it drops precipitously. Certainly some currencies display very fat tails: they tend to have long periods of stability, followed by one or more greater than five s.d. moves. (The interested reader may at this point wish to fit the Generalised Pareto Distribution to twenty or more years worth of dollar/yen returns, and compare the GPD VAR with the normal one at 99.99%: typically it’s very roughly four times higher.)
Krugman further suggests that a Wile E. Coyote moment may be approaching for the dollar. This is more than just suggesting that the dollar will fall: the fall has to be steep to qualify. Tanta over on Calculated Risk has some supporting evidence (which is a little glib but bear with me):
Bear in mind that the principal channel through which Fed policy affects domestic demand is via housing. If a burst housing bubble is part of the economic problem, the Fed’s leverage over the economy will be greatly reduced, and even a zero Fed funds rate might have only modest stimulative effect.
The problem is too many people are talking about this possibility: many currency strategists expect dollar weakening, so existing dollar shorts will tend to make large falls much less likely. The macroeconomic picture is not encouraging for the dollar, it’s true. As Long or Short Capital put it, albeit amusingly bluntly:
I challenge you to find one measure of wealth OTHER THAN THE DOLLAR which shows the US economy as worth more now than in 2001. If I wanted to buy our country it would cost me 30% fewer euros today than it did in 2001, it would cost me less bars of gold, less barrels of oil, less ounces of copper, less btu’s of natural gas, less cubic feet of lumber, less of almost anything that has intrinsic value. Yet you keep reporting GDP growth, why? Because your quick fix is to effectively print more money so that in dollar units everything is getting more “valuable”. But guess what, to the 95% of the world that doesn’t use dollars the true value of the US economy has been shrinking, rapidly.
Moreover, central banks, notably asian central banks, are not buying enough dollars to provide a floor. As Brad Setser says:
The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves. China’s central bank has made it known that it thinks it has enough reserves. Some in China think the PBoC already has far more reserves than it needs. Korea’s central bank has indicated — at various points in time — that it has more than enough salted away. The ADB agrees.
Still, currencies are often a long way from macro-economic equilibrium, and the U.S. has historically shown an astonishing ability to grow out of difficulties. Despite the fundamentals then instinct suggests that while one might not want to be short dollars yet. That just leaves buying the potential to benefit from a Wile E. moment via the options market. Perhaps selling short term downside gamma (in the belief that Wile E. will take a while to arrive at the cliff) generating cash to pay for a longer-dated further from the money position might be interesting.
I’m sure a salesperson will soon christen this ‘the Coyote trade’: look for a range of North American mammal structured notes at your friendly investment bank shortly.
An interesting post on the Street Light Blog, on currency misalignments, suggests an interesting question: is economics an equilibrium discipline? The very idea of a misaligned FX rate suggests that the natural state is an aligned one: perhaps the fundamentals move faster than the markets adjust, so FX is never in equilibrium. Perhaps (in the language of statistical mechanics) the relaxation time is much longer than the average time between forcings. Actually that makes a lot of sense…
Update. Paul Krugman seems to agree, at least in a limited context:
A free-market economy can get trapped for an extended period in a bad equilibrium in which good things are not demanded because they have never been supplied, and are not supplied because not enough people demand them