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how crowded is the short dollar trade?

Posted by WARREN MOSLER on April 29th, 2011

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.

11 Responses to “how crowded is the short dollar trade?”

  1. Sam Says:

    Hanky-Panky at the Fed
    Grand Theft Benny

    By MIKE WHITNEY

    It’s the biggest flim-flam in the nation’s history. But, thanks to the Congressional Research Service, the scam has been exposed and the public can now get a good look at the type of swindle that passes as monetary policy.

    Here’s the scoop: When Fed chairman Ben Bernanke initiated the first round of Quantitative Easing (QE), the stated goal was to revive the flagging housing market by purchasing $1.25 trillion in mortgage-backed securities (MBS) from the country’s biggest banks. The policy was a ripoff from the get-go. No one wanted these mortgage stinkbombs that were stitched together from subprime loans to unqualified applicants. But because the banks were already busted–and because the $700 billion TARP was barely enough to keep the ventilator running until the next bailout came through– the Fed helped to conceal its real objectives behind an elaborate PR smokescreen. In truth, the Fed must have colluded with the banks to move the toxic assets off their books (and onto the Fed’s balance sheet) with the proviso that the banks withhold foreclosed homes from the market…

    On Tuesday, Senator Bernie Sanders office released a CRS report titled “Banks Play Shell Game with Taxpayer Dollars” that sheds a bit light on the shady ways the Fed conducts its business. Sanders “found numerous instances during the financial crisis of 2008 and 2009 when banks took near zero-interest funds from the Federal Reserve and then loaned money back to the federal government on sweetheart terms for the banks.”

    So, now we have irrefutable proof that the Fed was simply handing out money to the banks. More importantly, the report shows that this was not just a few isolated incidents, but a pattern of abuse that increased as the needs of the banks became more pressing. In other words, giving away money became policy. Is it any wonder why the Fed has fought so ferociously to prevent an audit of its books?

    From Sander’s report: “The banks pocketed interest on government securities that paid rates up to 12 times greater than the Fed’s rock bottom interest charges, according to a Congressional Research Service analysis conducted for Sanders.”

    Are you kidding me; 12 times more than what the Fed was getting in return?

    That’s larceny, my friend. Grand larceny.

    More from the Sanders report: “This report confirms that ultra-low interest loans provided by the Federal Reserve during the financial crisis turned out to be direct corporate welfare to big banks,” Sanders said. “Instead of using the Fed loans to reinvest in the economy, some of the largest financial institutions in this country appear to have lent this money back to the federal government at a higher rate of interest by purchasing U.S. government securities.”

    What I’d like to know is whether the Fed has been creating reserves at the banks, reserves that the banks have then converted into government bonds (USTs) and sold back to the Fed during QE2? In other words, is this another circular trade (like we see in the Sanders report) whose only purpose is to funnel more money to the banks?

    And–if that’s NOT the case– then where did the banks come up with $600 billion in US Treasuries that they just sold to the Fed? After all, in testimony before the Financial Crisis Inquiry Commission (FCIC), Bernanke admitted that 12 of the 13 biggest banks in the country were underwater after Lehman Brothers defaulted. If that’s true, then where did they get the $600 billion in Treasuries?

    It’s not a question of whether the Fed has been abusing its power. It’s just a matter of “how much”

    Reply

    WARREN MOSLER Reply:

    you’re barking up the wrong tree. the fed’s policy tool is the bank’s cost of funds. tsy secs yielded more because of their longer maturities and therefore owning them involved interest rate risk- the risk that the fed would hike the cost of funds. and the 600 billion could have come from anywhere.

    I’m the fed’s harshest critic, as posted elsewhere on this website. Unfortunately most all other criticisms are wrong, and easily dismissed by the fed and others.

    Reply

  2. Max Says:

    Something I’ve wondered about…where do “carry trade” profits come from? Who are the losers?

    Reply

    WARREN MOSLER Reply:

    the losers are nations that don’t realize they should sustain a 0 rate policy and keep taxes at the right level for full employment, and have a JG program to ensure a channel from unemployment to private sector employment

    Reply

  3. roger erickson Says:

    I read this & feel like throwing something at a Goldman/MS/BA screen! This is just disgusting. I can’t believe they’re getting away with it. Urgency is battling poise, big time right now, and a cold determination is resulting.

    “It’s one thing to have a currency on the decline; it’s another thing to have GDP on the decline.”
    Exactly – but whose job is it to manage GDP? [hint: it begins with either Tr, Admin, Con or just "electorate", and NOT CB]

    (plus, where have the DOJ & FBI been? running out of fiat too?)

    “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?”
    Funding what? At whose discretion? How obscene is this? Everyone EXCEPT the average US citizen can borrow THEIR $US currency? Whose $ is it, anyway?
    (And who’s job is it to advise “us” on who is & isn’t worthy of receiving OUR loans? Why, those same mega banks that are lending our $ to themselves, seeing as how they’re so @#%& wise!!)

    And, to think that all these shenanigans have absolutely nothing to do with US public purpose … well, that’s just adding insult to injury

    We’re calling for cutbacks in national security spending so we can better support banksters illicit profits? And this is on top of foreclosuregate?

    WTF is going on in this country!? If Joe/Jane Sixpack ever gets wise to this there certainly SHOULD be blood in the Wall Streets. And also at all the fortune tellers in Omaha & other places.

    At best, this is what happens when people come to think that their trade (banking) is “indispensable”, and forget what it’s there for. At worst, it’s outright fraud & treason. You have to expect some of everything in between, and go look. Otherwise, we have no country, just a mob.

    Reply

    save america Reply:

    Roger asks: “where have the DOJ & FBI been?”

    Below is today’s slashdot article on where the FBI/DOJ has been. When financial crimes, hacker crimes, banker crimes, real murders and other crimes needing resources, its nice to know the teens at 4chan are being monitored for sending nudie pictures back and forth, like Hillary Clinton spending an awful lot of her time going after roman polanski for sex he got 30 years ago, good JOB!

    http://yro.slashdot.org/story/11/04/29/1948242/Department-of-Justice-FBI-Too-Focused-On-Child-Porn

    PS Roger, I think the “people” have woken up, they know they aren’t corrupt connected crony capitalists and will be slaves to thier dying day while illegal currency swaps/loans were done to other nations that they can’t vote in, but they are just too lazy to care and that would mean less time for celebrity apprentice and gary busey! LOL!

    Reply

  4. pebird Says:

    “Something I’ve wondered about…where do “carry trade” profits come from? Who are the losers?”

    “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
    — Warren Buffett

    Reply

    Sergei Reply:

    hysterical! and so true :(

    Reply

  5. Panayotis Says:

    Foreign exchange differentials are affected by both counterparty policy regimes. The dollar vis a vis the euro is also affected by the shift in the ECB stand for higher policy rates forward! trichet refinancing rate as well as Ben QE policies influence the exchange rate differential!

    Reply

  6. Curious Says:

    “Long gold, stocks, and other currencies… Best way to play it? Stay out of the way.”

    What do you own, if you want to stay out of the way?

    Reply

  7. WARREN MOSLER Says:

    own your house, maybe some other rental property, and keep enough cash around to not get squeezed out.

    Reply

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