how crowded is the short dollar trade?

Long gold, stocks, and other currencies is all the same trade, and all the specs and trend followers are in big, proving once again that the crowd isn’t always wrong.

Lack of understanding of what QE actually is seems to have scared everyone from portfolio managers and the man on the street to Putin to take action.

And Chairman Bernanke’s recent remarks, though fundamentally sound, gave them no comfort whatsoever, and only encourage this latest round of dollar selling and related trades.

No telling how long it will keep going.

But underneath it all the dollar’s fundamentals aren’t all that bad relative to the other currencies, apart from rising crude prices keeping the US import bill higher than otherwise, though partially offset by higher export prices, including food.

At last look trade gaps look to be ‘deteriorating’ in the eurozone, the UK, Japan, Canada, and Australia, as their currencies continue to climb, indicating they may have gotten past the humps in their J curves and trade flows have turned against them?

So looks to me like with the entire dollar move predominately driven by ‘hot money’ in the broad sense, there is nothing fundamental to get in the way of the reversal scenario suggested at the end of this article.

Best way to play it? Stay out of the way.

Cheap Dollar Fuels One-Way Bets in Everything Else

By Reuters

April 28 (Bloomberg) — Americans’ cheap money spigot remains open and the flow is as fast as ever, meaning the world had better brace for even higher oil, metals and food prices and a weaker dollar.

The clear message from Federal Reserve Chairman Ben Bernanke on Wednesday was that the U.S. central bank intends to keep interest rates exceptionally low and monetary policy very easy as it continues to try to inflate the U.S. economy back to health.

For investors, he offered further encouragement to keep borrowing in dollars, paying virtually nothing and then swapping those dollars into higher-yielding currencies or using them to buy oil, metals and food futures and options.

This so-called “carry trade” has become the trade du jour, particularly with the dollar’s precipitous drop of around 10 percent from its peak in January.

By comparison, U.S. crude futures are up 23 percent so far this year and the Thomson Reuters-Jefferies CRB index, a global index of commodities, is up 10 percent.

“The biggest risk right now is that Bernanke’s looseness creates the unintended consequence of boom-goes-bust, where easy-money-driven asset bubbles implode and confidence is consequently sucked out of the economy,” said JR Crooks, chief of research at investment advisory firm Black Swan Capital in Palm City, Florida.

“It’s one thing to have a currency on the decline; it’s another thing to have GDP on the decline.”

The “carry” trading tack is akin to the still popular yen-carry trade, which involves borrowing yen at Japan’s near-zero interest rates to purchase other higher-yielding securities such as Treasuries. Investors are borrowing in currencies like the dollar to fund purchases in markets with higher yields or currencies with potentially higher returns.

The Barclays’ G10 carry excess return index shows that borrowing in low-yielding currencies such as the greenback and buying those with high interest rates like the Australian dollar has generated returns of about 37 percent so far since the end of the financial crisis in early 2009.

“The Fed seems to be in no rush to tighten monetary policy. So if rates remain low, why shouldn’t the dollar be the preferred funding currency?” said Thomas Stolper, chief currency strategist at Goldman Sachs in London.

“And as you know in foreign exchange, it’s all about differentials between countries and in that respect, that differential is negative for the dollar,” Stolper added.

The yield differential continues to weigh against the dollar, particularly against the euro , the Australian dollar, and some emerging market currencies, whose central banks have started to raise interest rates.

Record low U.S. rates of zero to 0.25 percent, an enormous supply of liquidity under the Fed’s purchases of more than $2 trillion of Treasury and mortgage bonds, and improving economic prospects in emerging markets have prompted investors to borrow the lower-yielding dollar in carry trades over the last 18 months.

A rough estimate from investment advisory firm Pi Economics in Stamford, Connecticut, showed that the Fed’s easing may have fueled dollar carry trades in excess of $1 trillion, based on U.S. financial institutions’ net foreign assets positions.

On Wednesday, the dollar skidded to a three-year low of 73.284 as measured by the Intercontinental Exchange’s dollar index, down around 10 percent from its peak in January. Many traders expect the index to fall through the all-time low, hit in July 2008, of 70.698.

Feasible Alternative

For some investors, using the dollar in carry trades remains the only feasible alternative to other low-yielding currencies such as the yen and Swiss franc .

While the yen yields an interest rate of zero, like the dollar, the Japanese currency could strengthen if the economy goes into recession. Since Japan has huge overseas investments, a recession would prompt a repatriation of domestic investors’ funds to bolster savings, boosting the yen.

The Swiss economy is in much better shape than the United States and a rise in inflation there could well prompt the Swiss National Bank to raise interest rates, much like the European Central Bank did early this month.

That leaves the U.S. dollar as the only other option left to finance investors’ penchant for risk-taking.

“No one really thinks the Fed will hike rates significantly … They would want to keep rates low since the recovery is not that strong,” said Pablo Frei, a portfolio manager and senior analyst at Quaesta Capital, a Zurich-based fund of funds focused on currency managers, with assets under management of about $3.5 billion.

Frei said that although the dollar is a big short among hedge funds, “people have become more cautious of the risk of the dollar carry,” given how crowded this trade has become.

He added that the fund managers he tracks have reduced their short position on the dollar, although the lower-dollar bet remains their largest exposure.

As in any crowded trade, there is always the risk of a squeeze once things get sour, which could lead to a massive unwinding of carry trades and the potential for huge losses for those slow to get out. When global stocks drop, or when the risk barometer shoots up, investors tend to repatriate funds, close out losing carry trades and buy back currencies they had shorted.

This happened in 2008 during the global financial crisis and could well happen again.

An other-paradigm bludgeon?

>   
>   (email exchange)
>   
>   On Fri, Apr 29, 2011 at 10:10 AM, Arthur Patten wrote:
>   
>   Warren, just came across this 2008 paper. Authors find that most of the volatility in
>   standard inflation measures is due to relative price changes and that interest rates
>   are positively correlated with inflation. On behalf of the authors, you’re welcome!
>   

RELATIVE GOODS’ PRICES, PURE INFLATION, AND THE PHILLIPS CORRELATION

By Ricardo Reis and Mark W. Watson

August 2008

Department of Economics, Columbia University
Department of Economics and Woodrow Wilson School, Princeton University

Abstract (excerpts below): This paper uses a dynamic factor model for the quarterly changes in consumption goods’ prices to separate them into three independent components: idiosyncratic relative-price changes, a low-dimensional index of aggregate relative-price changes, and an index of equiproportional changes in all inflation rates, that we label “pure” inflation. The paper estimates the model on U.S. data since 1959, and it presents a simple structural model that relates the three components of price changes to fundamental economic shocks. We use the estimates of the pure inflation and aggregate relative-price components to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest. Conventional measures of relative prices are strongly but far from perfectly correlated with our relative-price index; pure inflation is only weakly correlated with money growth rates, but more strongly correlated with nominal interest rates. Second, what drives the Phillips correlation between inflation and measures of real activity? We find that the Phillips correlation essentially disappears once we control for goods’ relative-price changes.

QE and Real GDP

To which they respond ‘monetary policy works with a lag’

And to which I add, yes, it lags until the next fiscal adjustment kicks in.

;)

>   
>   But equities continue to peform relatively well.
>   

Yes, they should be ok with any positive top line growth.

The risks that remain are a hard landing in China, a euro zone meltdown, and fiscal responsibility in the US and Japan.

Goldman on monetary policy in the BRICs

Excellent recap of what’s happening through the eyes of Wall St. in the BRICS.

To be noted:

The BRICS all seem to be fighting inflation, which means the problem is that bad.

Unfortunately, hiking rates via direct rate hikes, reserve requirement hikes, and the like, which they all are doing, add to aggregate demand through the interest income channels, making their inflations that much worse. (That’s the price of being out of paradigm, as reinforced by analysts who are also out of paradigm)

Some are using credit controls, which do slow demand, as does fiscal tightening which generally happens through automatic stabilizers that work through higher nominal growth, including reduced transfer payments and higher tax receipts.

In general, this type of thing tends to end with a very hard landing, which their equity markets may be starting to discount.

BRICs Monthly : 11/04 – Monetary Policy in the BRICs

Published April 28, 2011

The BRICs’ central banks rely on a variety of tools to adjust monetary policy. As output gaps have closed and inflation pressures have accelerated, policy stances in the BRICs have shifted meaningfully towards tightening. We expect policy to continue to tighten in the coming months via a combination of policy rate hikes, reserve ratio requirement hikes and other measures.

There is a large degree of variation in the stated goals of monetary policy and the tools used to achieve those goals, both among the BRICs and relative to the advanced economies. The BRICs (like many other emerging markets) rely more heavily on a broader set of tools than is typical in the developed world. These include several policy rates, reserve ratio requirements, open market operations and FX intervention. As a result, looking at the policy rate alone does not provide an accurate picture of the overall monetary policy stance.

Over the past year, BRICs’ policymakers have shifted from an accommodative policy stance (in response to the financial crisis) to tightening (in response to closing output gaps and rising inflation pressures). However, the unusual shape of the global recovery—in which most of the BRICs and other EMs have rebounded quickly, while the developed world has lagged behind—has brought about a shift in the way in which the BRICs have tightened monetary policy. This time around, most have relied less on policy rate hikes and more on alternative tools.

While the BRICs have tightened monetary policy meaningfully, we believe that more is on the way. We expect Brazil, India and Russia to hike their policy rate by another 125bp and China to hike by 25bp by end-2011. In addition, we expect further tightening through the exchange rate, the reserve requirement ratio and other measures.

Monetary Policy in the BRICs

There is a large degree of variation in the stated goals of monetary policy and the tools used to achieve those goals, both among the BRICs and relative to advanced countries. The BRICs (like many other EMs) rely more heavily on a broader set of tools than is typical in the developed world. Hence, looking at the policy rate alone does not provide an accurate picture of their monetary policy stance.

Brazil’s monetary policy framework has shifted dramatically over the past two decades. As it struggled against hyper- and high inflation in the early 1990s, the government first introduced a period of extremely high interest rates (over 50%) in 1994, and then transitioned in 1995 to a soft exchange rate peg accompanied by high and volatile interest rates. In 1999, Brazil shifted to its current inflation-targeting regime. The current inflation target is set at 4.5%, with a relatively wide band of +/- 2% and no repercussions if the target is missed (as it has been for the past three years). To this end, COPOM targets the SELIC interest rate (the overnight interbank rate).

China uses a more eclectic form of monetary policy that involves a range of players, objectives and instruments. The People’s Bank of China (PBoC) is the official implementer, but the central government often weighs heavily on the PBoC’s decisions. The Bank does not hold regular policy meetings and policy changes are typically released after the close of the local market without advance notice. The Monetary Policy Committee of the PBoC is an advisory body, which does not determine policy direction. Chinese monetary policy has an official quad mandate of growth, employment, inflation and a balanced external account. To achieve these goals, the PBoC uses a range of quantity- and price-based mechanisms, such that there is no single policy instrument that can be used as a main indicator of its monetary policy stance at any given time. Quantity-based tools include reserve requirement (RRR) changes and credit controls. Price-based tools include changes in the benchmark deposit and lending interest rates.

India’s monetary policy is conducted by the Reserve Bank of India (RBI), which has the dual mandate of price stability and the provision of credit to productive sectors to support growth. To this end, the RBI targets the interest rate corridor for overnight money market rates, with the reverse-repo rate as the floor and the repo rate as the ceiling. The RBI also utilises open market operations and two types of reserve ratio requirements (the cash reserve ratio and the statutory liquidity ratio).

In Russia, monetary policy is set by the Central Bank of Russia (CBR). Until recently, the CBR concentrated on exchange rate stability and allowed inflation to vary. Its main policy rates are the overnight deposit rate and the 1-week minimum repo rate, although these historically have played a subordinate role to FX intervention. The CBR also monitors liquidity through reserve requirements, FX interventions and open market operations.

Shift in BRICs’ Approach to Monetary Tightening

The unusual shape of the global recovery—in which most of the BRICs and other EMs have rebounded quickly, while the developed world has lagged—has brought about a shift in the way in which the BRICs have tightened monetary policy.

Policymakers in Brazil have been hesitant to raise rates as aggressively as they normally would in response to the current high-growth/high-inflation domestic cyclical picture, given their concern that this would attract greater capital inflows. Instead, they have increasingly relied on two alternative mechanisms to tighten the overall policy stance: (1) a gradual FX appreciation and (2) several ‘macro-prudential’ measures that slow the pace of new credit concessions, raise the cost and lengthen the maturity of new loans, and raise the tax on foreign fixed income inflows.

Over the recent cycle, Chinese policymakers have relied most heavily on explicit and implicit credit controls, including window guidance meetings and the Dynamic Differentiated RRR System (under which the PBoC imposes a differentiated RRR for some banks but removes it for others, if they have been following government lending controls). Frequent RRR hikes have generally not produced any net tightening, as they were counterbalanced by increased FX inflows and expiring central bank bills. Likewise, recent interest rate hikes have been an effective signalling device but have been too small in magnitude to have a large impact.

In India, the RBI has kept liquidity tight in order to pass policy rate hikes through to bank deposit and lending rates. However, excessively tight and volatile liquidity has caused overnight borrowing rates to fluctuate widely in recent months, such that market participants have focused more on liquidity than policy rate actions in determining the direction and magnitude of interest rates at the short end. In an effort to address this issue and increase transparency, the RBI has proposed shifting to a single policy rate target (the repo rate) while simultaneously improving its control over system-wide liquidity.

Russia has seen the largest change in its monetary policy framework since the onset of the financial crisis. The CBR has shifted towards more FX flexibility with a greater focus on inflation, with the goal of an eventual move towards an inflation targeting regime (although, as the CBR has highlighted, such a move would ultimately be a government decision, which is unlikely to be realised in the absence of a strong political will to make the change). To this end, the CBR has moved towards interest rates as its primary monetary policy tool, and has scaled down its presence in the FX markets. It now sterilizes most FX interventions so as not to impact money supply growth. It has also relied more heavily on reserve requirement changes in recent months, in an effort to signal tightening liquidity.

More Tightening to Come

While the BRICs have meaningfully tightened monetary policy via a variety of tools, we believe more is needed. Demand-driven inflationary pressures are picking up as output gaps close, contributing to an acceleration in core inflation. Moreover, the BRICs also face large food and energy price spikes, which are likely to continue to push up headline inflation at least through the summer. In addition, fiscal policy is not turning sufficiently contractionary, leaving the burden of tightening on monetary policymakers.

In Brazil, we expect five more SELIC hikes by 25bp per meeting and further macro-prudential measures. For China, we forecast at least one more rate hike (25bp in 2011Q2), further currency appreciation (6% annualised), liquidity absorption measures through RRR hikes and open market operations, and tight control over credit issuance. We have a much more hawkish view of India than consensus, where we now expect the RBI to hike policy rates by another 125bp in 2011. Russia’s CBR should hike deposit and repo rates by 150bp and 125bp respectively by end-2011.