Back to Carry Trades
Andy Xie (Hong Kong)
Carry trades are dominating investment themes among the financial investors I visited in the UK last week. Long commodities and emerging markets and short on the US dollar seem to remain the core investment ideas. The expected revaluation of the renminbi, continued strong demand from China for commodities, and the large US current account deficit are the three building blocks for the carry trades.
The reviving enthusiasm for carry trades after a lull in the spring and summer is due to several factors. 1) China did not raise interest rates in September, 2) the level of liquidity, especially the flow into hedge funds, has remained strong despite three Federal Reserve rate hikes, and 3) there is still nothing else to be really bullish about.
While the recent rate hike by China is denting the enthusiasm for carry trades, its impact is unlikely to last. We believe the carry trades will truly unwind when the Fed funds rate is significantly above inflation and/or there is physical evidence that China’s demand for commodities has declined.
Putting on Carry Trades Again
The hedge fund community in London has grown rapidly. I spent three days in London last week and did not feel unproductive. The city appears to have successfully made the transition from a center for traditional money managers to one for hedge funds in the two years since the former was decimated by the tech burst. I believe this speaks volumes on how flexible and dynamic London’s financial community is in taking advantage of the shift to absolute from relative performance in the money management business.
The mood of investors I met was somber in general. The seesawing market conditions have made it difficult to make money this year. Even hedge funds can only make money when there are trends to catch. The recent weakness in the US dollar, which has made carry trades profitable again, has not been big enough to change the investor mood.
Most investors I met in London have convictions on going long emerging markets (equity, credits or currencies) and commodities (commodity futures, currencies or commodity producers) and are short on the US dollar or long on the yen, euro and emerging market currencies. The US current account deficit, expected renminbi revaluation and continuing strong demand for commodities from China are the fundamental arguments in favor of the carry trades.
Low Fed Funds Rate Still Drives Carry Trades
The low Fed funds rate is the source of enthusiasm for carry trades. Even though the Fed has raised the rate by 75bps, it is still substantially below the inflation rate in the dollar block (East Asia plus US). The US liquidity indicators are all turning down but the level of liquidity is still high. The amount of liquidity with money managers, especially in hedge funds, is still significant. Another 100bps of rate hikes by the Fed could reverse this liquidity tide.
Most money managers I have met are expecting stock markets to rally after the US election. If oil prices come down, which is already taking place after China’s rate hike, this should be the case and would be another example of a self-fulfilling expectation in a world with too much liquidity.
The carry trades will only work for everyone if China revalues its currency, which would cause another round of US dollar weakness and an even bigger commodity bubble. If China raises interest rates but keeps the peg, as I believe, carry trades will be a negative sum game for all participants.
Dollar Devaluation Is the Wrong Solution to Global Imbalance
The case for a weaker US dollar is the large US current account deficit, as it reduces the deficit through more exports and/or more import substitution. However, last year’s dollar devaluation had the opposite result. The main reasons for this were: 1) that consumption in other major economies would not rise much, given their stronger currencies and 2) that global companies have spread their capacity to lower-cost locations and could meet more US demand with foreign production. Therefore, the level of globalization has changed how currencies affect economies.
I believe the right solution to the US current account deficit or the global imbalance is for a US consumption correction. The US consumer has overspent in the past four years. Two to three years of below-trend growth, say 2-3%, could well correct the global imbalance. In my view, this would not be such a high price to pay for the consumption binge that has been going on in the US.
The US dollar is the anchor currency for globalization (i.e., global trade). Devaluing this anchor currency to gain trade advantages just does not work. If policymakers insist on pushing the dollar down, there may be global financial crisis. Two to three years of US consumption weakness would be more preferable for everyone, in my opinion.
China's Outlook Does Not Support Carry Trades
I believe an overwhelming majority of money managers are on the same side of carry trades, pushing up commodity prices and pushing the dollar down. The only way for everyone to make money is for the global equilibrium to change to justify a lower dollar value and higher commodity prices. A revaluation of the renminbi would have done the trick, which is why the expectation of a Chinese currency revaluation was so central to the carry trades around the world.
The rate hike by China shook the confidence in this plan a little, as the market had thought China would deal with inflation by raising the currency’s value rather than increasing interest rates to slow demand. This undermined the fundamental assumption for carry trades. Oil prices appear to have declined in response to China's rate hike as some speculative positions were unwound.
However, most money managers appear to have found a way to interpret the rate hike in favor of carry trades: if China could increase interest rates suddenly, it could also just as suddenly increase the value of the renminbi. In my view, this expectation is what continues to support the carry trades that are prevalent in currency and commodity markets.
I believe that China will continue to raise interest rates along with the Fed but keep the currency stable. With the economy in overshooting territory and surrounded by a lot of speculation, appreciating the currency – even if it is small amount – could cause speculation to mushroom and thus create a bigger bubble, with a big crash bound to follow. In my view, China is unlikely to take such a risk.
I believe the best course of action for China is to gradually raise interest rates to maximize the economy’s chances of landing softly. Only after this has occurred should China contemplate exchange rate reform.
Andy Xie (Hong Kong)
Carry trades are dominating investment themes among the financial investors I visited in the UK last week. Long commodities and emerging markets and short on the US dollar seem to remain the core investment ideas. The expected revaluation of the renminbi, continued strong demand from China for commodities, and the large US current account deficit are the three building blocks for the carry trades.
The reviving enthusiasm for carry trades after a lull in the spring and summer is due to several factors. 1) China did not raise interest rates in September, 2) the level of liquidity, especially the flow into hedge funds, has remained strong despite three Federal Reserve rate hikes, and 3) there is still nothing else to be really bullish about.
While the recent rate hike by China is denting the enthusiasm for carry trades, its impact is unlikely to last. We believe the carry trades will truly unwind when the Fed funds rate is significantly above inflation and/or there is physical evidence that China’s demand for commodities has declined.
Putting on Carry Trades Again
The hedge fund community in London has grown rapidly. I spent three days in London last week and did not feel unproductive. The city appears to have successfully made the transition from a center for traditional money managers to one for hedge funds in the two years since the former was decimated by the tech burst. I believe this speaks volumes on how flexible and dynamic London’s financial community is in taking advantage of the shift to absolute from relative performance in the money management business.
The mood of investors I met was somber in general. The seesawing market conditions have made it difficult to make money this year. Even hedge funds can only make money when there are trends to catch. The recent weakness in the US dollar, which has made carry trades profitable again, has not been big enough to change the investor mood.
Most investors I met in London have convictions on going long emerging markets (equity, credits or currencies) and commodities (commodity futures, currencies or commodity producers) and are short on the US dollar or long on the yen, euro and emerging market currencies. The US current account deficit, expected renminbi revaluation and continuing strong demand for commodities from China are the fundamental arguments in favor of the carry trades.
Low Fed Funds Rate Still Drives Carry Trades
The low Fed funds rate is the source of enthusiasm for carry trades. Even though the Fed has raised the rate by 75bps, it is still substantially below the inflation rate in the dollar block (East Asia plus US). The US liquidity indicators are all turning down but the level of liquidity is still high. The amount of liquidity with money managers, especially in hedge funds, is still significant. Another 100bps of rate hikes by the Fed could reverse this liquidity tide.
Most money managers I have met are expecting stock markets to rally after the US election. If oil prices come down, which is already taking place after China’s rate hike, this should be the case and would be another example of a self-fulfilling expectation in a world with too much liquidity.
The carry trades will only work for everyone if China revalues its currency, which would cause another round of US dollar weakness and an even bigger commodity bubble. If China raises interest rates but keeps the peg, as I believe, carry trades will be a negative sum game for all participants.
Dollar Devaluation Is the Wrong Solution to Global Imbalance
The case for a weaker US dollar is the large US current account deficit, as it reduces the deficit through more exports and/or more import substitution. However, last year’s dollar devaluation had the opposite result. The main reasons for this were: 1) that consumption in other major economies would not rise much, given their stronger currencies and 2) that global companies have spread their capacity to lower-cost locations and could meet more US demand with foreign production. Therefore, the level of globalization has changed how currencies affect economies.
I believe the right solution to the US current account deficit or the global imbalance is for a US consumption correction. The US consumer has overspent in the past four years. Two to three years of below-trend growth, say 2-3%, could well correct the global imbalance. In my view, this would not be such a high price to pay for the consumption binge that has been going on in the US.
The US dollar is the anchor currency for globalization (i.e., global trade). Devaluing this anchor currency to gain trade advantages just does not work. If policymakers insist on pushing the dollar down, there may be global financial crisis. Two to three years of US consumption weakness would be more preferable for everyone, in my opinion.
China's Outlook Does Not Support Carry Trades
I believe an overwhelming majority of money managers are on the same side of carry trades, pushing up commodity prices and pushing the dollar down. The only way for everyone to make money is for the global equilibrium to change to justify a lower dollar value and higher commodity prices. A revaluation of the renminbi would have done the trick, which is why the expectation of a Chinese currency revaluation was so central to the carry trades around the world.
The rate hike by China shook the confidence in this plan a little, as the market had thought China would deal with inflation by raising the currency’s value rather than increasing interest rates to slow demand. This undermined the fundamental assumption for carry trades. Oil prices appear to have declined in response to China's rate hike as some speculative positions were unwound.
However, most money managers appear to have found a way to interpret the rate hike in favor of carry trades: if China could increase interest rates suddenly, it could also just as suddenly increase the value of the renminbi. In my view, this expectation is what continues to support the carry trades that are prevalent in currency and commodity markets.
I believe that China will continue to raise interest rates along with the Fed but keep the currency stable. With the economy in overshooting territory and surrounded by a lot of speculation, appreciating the currency – even if it is small amount – could cause speculation to mushroom and thus create a bigger bubble, with a big crash bound to follow. In my view, China is unlikely to take such a risk.
I believe the best course of action for China is to gradually raise interest rates to maximize the economy’s chances of landing softly. Only after this has occurred should China contemplate exchange rate reform.
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