QEII and the Carry Trade

The Fed is engaged in a second round of quantitative easing. This seems necessary given the low probability of any future fiscal stimulus. But what if the increase in liquidity just further fuels the carry trade? Interest rates are so low that investors are borrowing dollars and investing in emerging market economies to earn higher rates. As Japan used to be the borrowing center for the carry trade, now it is us.

Of course, the carry trade is more profitable if the dollar depreciates relative to other currencies. If QEII is effective in generating some extra inflation, and if investors expect this, this will induce carry traders even further, unless nominal interest rise right away. The Fisher effect would predict an immediate rise in nominal interest rates to compensate for expected inflation. But we are not seeing that. But if investors expect future dollar depreciation even without a current interest rate response we get a super environment of the carry trade.

That may be why so many emerging market economies are mad. They are getting the brunt of the carry trade impact.