Tuesday, November 3, 2009

Correspondence

A friend writes in response to yesterday's quote of the day:
What the fuck does that mean?


Buttonwood was talking about the carry trade, which he explained thusly, "The essence of the trade is that investors borrow in a low-yielding currency to invest in higher-yielding regimes (or to buy assets)."

Step 1: You borrow in dollars at roughly zero percent interest.
Step 2: Invest it where interest rates are above zero.
Step 3: Profit.

Let's look at the carry trade a bit more closely. Basically, the money you make on the trade is determined by two things. First, the difference in the interest rate. Second, any changes in the exchange rate. Most carry traders would be happy if the exchange rate didn't change. Meaning that they just get the money from the differing interest rates at zero risk. If you borrow for ninety days in dollars and then invest it for 90 days in some other currency at a higher interest rate without any changes in the value of the currencies, then you've got a license to print money.

What's interesting about the carry trade is that it's self-reinforcing. When I borrow money in dollars and then sell them to buy something else, say euros, I put downward pressure on the dollar and upward pressure on the euro. My sale by itself is negligible, but when a bunch of people start doing the same thing it will push the dollar down and the euro up. And we all make more money. This is what happened with the Japanese housewives and the Yen carry trade. They pushed the Yen lower and the Australian currency higher and made money on the currency fluctuation as well as the interest rate differential.

Buttonwood explains, however, that this shouldn't ever work:
In theory, the carry trade shouldn't work. Any difference between interest rates in, say, the US and Australia should reflect either higher inflation in one country or the other or the expectation that one currency will depreciate against the other. Indeed, thanks to arbitrage, forward currency rates rigidly reflect interest rate differentials.


There are two basic formulas for determining currency prices. One, for the short-term, is interest rate parity, which is what Buttonwood says forward currency rates rigidly reflect. Basically, this says that everybody plans for the currency fluctuations to cancel out the money that could be made by the difference in the interest rates. The second formula for determining currency prices involves, as Buttonwood suggests, the differences in the inflation rates between two currencies. This is the standard way to predict currency prices over the longer term. Basically, if inflation is running at a higher rate in the US than Australia, then the dollar will be worth less in the future. This makes intuitive sense. If the dollar buys less shit here because of inflation, then it should buy less shit in Australia as well.

An important point to note is that interest rates and inflation are directly related. The Fed raises and lowers the interest rate to manage inflation. This brings me to what Buttonwood was explaining here:
Lee argues that the carry trade has two prerequisites; interference in the markets by governments and weak domestic credit demand. The first is currently present; plenty of governments (including China's) are preventing their currencies from rising too far against the dollar.


Interference by governments makes sense as a prerequisite. As I mentioned above, the exchange rates should change to cancel out any benefits from interest rate differentials. Government intervention distorts the exchange rates and so they don' cancel the interest rate differential out and there is profit to be made. The second point is related to the interaction between monetary policy, ie interest rates, not exchange rates.

It's kinda like this: The Fed lower interest rates to encourage people to borrow more. (That's where the point about the weak credit market comes in. If people want to borrow in the country, then it makes it harder to borrow to do the carry trade.) As people borrow and lend, this creates more money though an effect called the money multiplier. The Fed would then see that lots of money has been created and respond by raising interest rates to lower borrowing, and rein it back in.

Ah, but the carry trade disrupts this. People borrow money, but then lend it in another currency. This means the Fed's policies aren't having quite the same effect that they think it is. When they raise interest rates it will screw up the carry trade. The dollar will rise even more than the change in interest rates would normally cause.

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