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.

Flight to Safety

The unwinding of the carry trade and the flight to safety is causing the yen and dollar to appreciate. This is what is spreading the crisis to many emerging markets.

I gave a talk on the financial crisis this week and I noted that this crisis was unlike typical ones in one big way. When most countries experience a financial crisis currency flows out and the biggest problem is to defend the currency. The IMF then comes in and pushes lower government spending to create confidence in the future of the economy. But our crisis has caused the dollar to appreciate as the whole world demands the safety of the dollar. Hence, our government is increasing spending. We have created a new type of financial crisis. That is the risk when it comes from the financial center.

End of the Carry Trade

The carry trade is a bet where you borrow at low interest rates and lend at high rates. Typically, you borrow in Japan and invest in Australia. Your bet is that the interest differentials are not signaling that the Yen will strengthen relative to the weaker currency. For long periods you make small gains. Iceland seemed to be operating as a huge carry trade hedge fund.

It seems now, however, that the carry trade may be ending. The Yen is strengthening in the wake of the crisis. Notice that the carry trade is a bet that markets are not efficient -- that interest parity will not hold. For long periods of time it seems that one can make money going against this. But eventually the reckoning occurs. The problem with such bets is that when they unravel it is a very hard landing.

The carry trade was very profitable for years prior to the Asian crisis. But it unwound quickly and caused large losses when the Yen did appreciate. I wonder if the current unwinding will spread the pain now.