Carry Trade Implosion: Again
Recent slide in markets is mainly attributed to the implosion of economies in PIGS (Portugal, Ireland, Greece and Spain). While this is going on,rumor is that Goldman is incurring significant losses YTD (year-to-date) on carry trade and may have to place stop-loss orders. One might ask, “What is a carry-trade?” I was going to explain. But, I already found an explanation on the internet.
The basic mechanics of a carry trade involve borrowing in one currency that offers a low interest rate, and selling it in favor of a higher-yielding currency, in order to capture the interest rate spread. This strategy carries two key risks. The first risk is that the “long” currency will depreciate. This also includes country risk, the possibility that political or macroeconomic instability will adversely affect the long currency. Then, there is the risk that the interest rate differential will change such that the spread shrinks, and a smaller carry is earned. For a while, the most popular funding currency was the Japanese Yen, with its negative real interest rates. Now, however, the Dollar has become a popular funding currency, due to low interest rates and a self-fulfilling belief that it will continue to depreciate.
That is enough explanation. You put a bunch of math geeks in charge of Wall Street’s speculative trading machine. They derive fancy equations for understanding and mitigating risk. They tell traders to borrow in one currency and ‘invest’ in another – “risk-free!” That was the modus operandi in the 90s and 00s. Come 2008 crash – carry trade imploded. Have no fear. The government is there to spread the risk to unsuspecting public via bailouts. The traders at the likes of Goldman Sachs got emboldened. This is carry-trade redux alright. How bad is the problem? Very bad if you are short US Dollar and long Euro, or Danish Krone or Brazil Real – up to over 6% lass in just one month (see chart). [Yes, 6% is a lot of moolah because the smarty pants (aka speculators) on Wall Street do carry trade in billions of dollars.]
