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Dollar index is below 90. To be more specific it is at 89.80 as we write this. When was the last time it was below 90? It traded below 90 briefly around end of February and prior to that in December. The other currencies consequently are their near-term highs, Euro is above 1.22, Pound is nearing 1.42, South African ZAR poised to break 14 and the Indian Rupee hovering around 73. Now a retreating Dollar is a harbinger of risk on. All the infinite variables which we study from inflation to job openings, from wage gains to new home build ups, from retail sales to PMIs ultimately feed into two variables i.e. Dollar index and US yields (10-year as a reference). Though one should be wary of declaring victory prematurely but still the odds are stacked favourably for things to improve. The pandemic at least in economic engines of the world (US, EU, UK, China, Far East) has been more or less been controlled (with vaccines etc). Interest rates continue to be low. In short good times beckon.
Now let’s try to see the above from the angle of a curious phenomenon called carry trade. Dollar index going down also represents the onset of carry trade in one sense. Borrow in Dollar, convert in another currency (with high interest rate), deploy in that country’s asset, make the differential and re convert to Dollar at the end of the trade to pocket the gains. Theoretically the inflation differential between two economies should result in the depreciation of HY currency resulting in neither a gain nor a loss at the end of such trade. You gain the interest differential but lose as the currency gets depreciated. But things are rarely so simple.
The influx of Dollars in any economy will result in its central bank scooping up the extra Dollars and bulking up their reserves. This will hold the currency from appreciating. These Dollars will be sold off when the reversal of carry trade happens (assumption alert!) to support the currency from depreciating. The net effect is that the currency remains stable. Now the readers can see the point which we are trying to make. To negate the effect of hot money what different central banks end up doing is entering into a volatility suppression trade providing a free pass to the carry trader.
Authors Tim Lee, Jamie Lee and Kevin Coldiron describe this phenomenon in detail in their 2020 book, The rise of Carry. Authors discuss in detail the various manifestations of carry which doesn’t always involve a foreign asset manager trying to benefit from this phenomenon. Take for example a Turkish corporate which takes a Dollar loan instead of borrowing in the Turkish Lira market. Rather than paying a high teen cost in local currency it enjoys getting funded at a cheap Dollar rate. When it converts the Dollar to Lira locally, the central bank’s action is same, it has to buy extra Dollars. Now two things need to be kept in mind here. While the carry money is coming in, the liquidity increases, the market becomes deep, bid ask spreads narrow. The reverse is also true. But the more important thing to note is that while the inflow is gradual and steady. The outflow is sudden and normally resembles a stampede like situation. Authors describe it as sawtooth return phenomenon.
As we need to keep length of communique in mind we will stop here and continue this discussion later. We will see the FOMC minutes today and sieve it in detail to identify any hawkish or dovish signs. We plan to take the Fed structure and history in detail in coming days for our readers so that they can fully appreciate it is not a monolithic structure. The Fed governor and FOMC is only the most visible part of a well-oiled gargantuan machine. But that for some later day.