How the "Carry Trade" and Capital Tsunamis Are Pushing the Gold Price Up
Source: Julian D.W. Phillips, Gold Forecaster - Global Watch (12/7/07)
The gold price has not only been reacting to the absolute levels of the oil price and the fall of the $, but to the instability, uncertainty and downright fear in the Capital markets and the banking system.
One wrong picture we must correct is that it is Japanese Housewives who are behind the “carry trade”. This is a cute but ridiculous concept. The “carry trade” is a group title for a type of trading carried on all over the world where interest rate differentials allow borrowing in one currency to lend in another. Any currency trader anywhere in the world can do this is he has the requisite standing with the banks. The bulk of these traders are housed in massive dealing rooms in the vast majority of the banks in the world. These operations may sound simple on the surface, but in reality can be difficult to assess accurately and even more difficult to execute. The currency traders at the world banks and they watch their screens every moment, moving and trading with every change in exchange rates, closely in touch with in-house research. These are clever young lads; working for their annual bonus with an eye on the latest Porsche. They have enormous financial power, but are held on a tight leash by their bosses.
The ‘carry trade’ concept comes with exchange rate risks, which are part of the assessment of potential profits. The Yen was ideal because it was relatively stable against the U.S.$ until recently after a weakening trend over the last year as it fell from around Y100:$1 to Y122:$1. Then in the last month the Yen turned viciously onto a strengthening trend, taking it back to Y109:$1. The question now is will the Yen weaken again? If it does then the ‘carry trade’ opportunity reappears.
But to even think that only the Yen has to be part of this business is again naïve. The speed of the change in the Yen’s value was probably precipitated by these traders as they saw the dangers of a Yen strengthening and a $ weakening. What would you do in that position? Why, close out your borrowing in Yen and open it in the $ where interest rates and the exchange rates turned down. If you had lent into the € or the NZ$ or the Australian $, or even the € and you would hold that position, setting it against the U.S.$. With a strengthening of the Yen, you wait until it peaks [in your opinion] then reopen your borrowing in Yen and close it in the U.S. $. These are short-term traders who like positions to hold as long as they can to maximize interest income, but stay nimble on their toes, grabbing each opportunity as it rises and closing positions in a heartbeat. At times working these desks can be as exciting as driving a Ferrari. No wonder these Traders are burned out by the time they reach 40.
They contribute heavily to the creation of massive Capital flows that create the rising volatility in the markets that we are seeing right now. Combine these with other Soros like Traders alongside genuine Investors like Sovereign wealth funds, you not only have potentially massive Capital Tsunamis, you have a very real precipitant for much more uncertainty and instability. One crack in the hull of the global monetary system and the capital will flood out or in.
The Capital Tsunami’s won’t go away
Using the $ to pay for purchases of currencies with higher yields is proving to be the most profitable trade in the foreign-exchange market amongst the “Carry Trade”.
A basket of currencies including the British Pound, Brazilian Real, and Hungarian Forint financed with dollars returned 17% this year, compared with 9% when funded in the Yen and 7% in Swiss Francs. Falling U.S. interest rates and increasing volatility in the Yen and Franc are making the trade even more appealing. With the $ giving the appearance of being in free fall, it increases the attractiveness of using the currency to fund investments.
The last time the U.S. $ was used for so-called “carry trades” was in 2004, when the Federal Reserve's target rate for overnight loans between banks was 1%. Since then, it has weakened 18% on a trade-weighted basis. The International Monetary Fund says the $ made up 64.8% of central banks' currency reserves in the second quarter, down from 71% in 1999, after the € was introduced.
Investors are borrowing the $ and using the money to buy assets in countries with higher interest rates even though U.S. borrowing costs are 4% points more than the Bank of Japan's and 1.75% points above the Swiss National Bank benchmark. Investors may switch more than $100 billion of borrowing from Yen or Francs into the $ in the next two years for ‘carry trades’.
The value of futures contracts held this month by hedge funds and traders betting against the $ was a record $33.9 billion more than contracts that profit from a gain. Pacific Investment Management Co., which oversees the world's biggest managed bond fund, is selling dollars against the Brazil Real, Mexican Peso, Korean Won, and Singapore $. "When we think about currencies on a three-to-five-year basis we're very bullish on emerging markets versus the U.S. dollar," said Pimco. "That view is only reinforced when you look at interest-rate differentials." The Real rose 18.5% this year and Singapore's currency strengthened 6.4%, while the Won was little changed. The Mexican Peso fell 1.4%, the only one of the 16 most-traded currencies to do worse in the foreign exchange market.
Using a currency to finance trades does drive down its value as we saw in the exchange rate of the Yen. Former Japanese vice finance minister Hiroshi Watanabe said in May that one reason the Yen had fallen to a record low against the € was because it was funding about $500 billion of “carry trades”. All in all the above information confirms that “Carry Trading” is here to stay and getting bigger and bigger. It is a large contributor to the volatility of exchange rates and financial ruptures in the world money system. It is “hot money” and likely to fuel speculation against vulnerable currencies.
The instability and uncertainty such trading fuels will continue to make gold more and more attractive and the foundation of paper money more and more fragile. When one hears the Fed Chairman reflect this atmosphere, you just know some will seek the safety of gold, at least. But some will become many as instability and uncertainty is reflected in many market places.
Shortly in our pages, we will be covering just how “Marginal Supply” and “Syndications” have also contributed to the instability and uncertainty has and will contribute to making gold attractive, short, medium and long-term.