So Far It’s NOT about the Carry Trade!

``The potential of the carry trade as a source of future exchange rate volatility has brought back memories of October 1998 when the yen collapsed against the dollar as hedge funds unwound carry trades in response to the Russian financial crisis.”-Peter Garnham and David Pilling, Financial Times

Well, some have argued that the recent plunge in US and global stocks have been due to the unwinding of the carry trade.

Figure 4: stockcharts.com: Rising US dollar; Falling Yen and Swiss franc

Figure 4 tells us that the so-called CARRY Trade has NOT been much of a factor in the recent selloff YET, as both funding currencies of the Japanese Yen (upper window) and the Swiss Franc (lower window), has contrary to expectations, continued to encounter marked declines amidst rising volatility.

Instead we see a rallying US dollar traded weighted index and a return to a positive yield slope in our midst. (Yes the Philippine Peso declined abruptly by 1.28% to Php 46.67 alongside with most of the region’s currencies, aside from an equivalent tremblor in the region’s bond markets).

The Carry trade assumes borrowing or shorting low yielding currencies and utilizing the proceeds to invest in higher yielding currency/assets. However if the costs of these currencies rises, there could be pressures to sell the invested assets and payback the loans or buyback the shorted currency, where such offsetting transactions would result to across the board selling pressures in the traditional high risk asset market classes like the emerging market assets, commodities and corporate junk bonds. We have not seen this happen yet.

In other words, if one were to speculate on whether today’s shakeout has impaired the system of leverage from which the global markets operate on, then the depiction of insouciance by the Yen and Franc as funding currencies to such levered transactions shows that either these Carry trades have produced insignificant bearing in last week’s activities or has not reached its stress level enough to trigger the purported systemic risks.

Considering the actions of the tape here and abroad, what we are in essence witnessing is a simple return to cash, from regular profit-taking activities, instead of a market bedlam as some bears suggest, of course, until prove otherwise.

Let me quote Chris Gaffney, Vice President of the EverBank World Markets, ``Eventually this cash will need to be put back to work, or will be used to pay off the loans which many of these investors have used to create the explosion of liquidity we have seen over the past few years. As I have said in the past, many loans are denominated in the lowest yielding currencies, the Japanese Yen and the Swiss Franc. If / when investors finally decide to pay back these loans, they will need to buy both of these currencies and the 'carry trade' will be reversed. As I mentioned above, I think blaming a reversal of the carry trade for the move in currencies overnight just doesn't make sense (emphasis mine). But, at the same time, I do believe we have seen the first step in a reversal of this trade.”