Given the choice between loans with identical terms, one would always pick the lower interest rate. Institutional investors also generally pick the currency with the lowest rate when they choose which one to denominate their loans in. For example, when a trader is long AUD/USD, he receives the difference between the two country’s interest rates -- in this case the trader is credited 2.75% (3% AUD minus .25% USD). This is called a “carry trade.”
Markets can move fast when they head down, and when a carry trade unwinds, few things move faster. Let’s take a look at the benefits and risks of the U.S. becoming the low-interest-rate capital of the world.
As the recession has taken hold, short-term U.S. interest rates have been pushed down to .25% or lower. (The current rate on the 13-week Treasury bill is .09%.) These low rates encourage those who want to borrow to do so in U.S. dollars, which is exactly how the low Japanese interest rates of the past boom cycle encouraged borrowing in yen.
During the inflationary boom of 2002-2007, the yen carry trade fueled many loans at the low cost of .25%. The yen-denominated loans allowed for strength in other assets in an apparent self-reinforcing cycle. That led to substantial yen weakness, especially versus the euro and Australian dollar where EUR/JPY gained 38% and AUD/JPY gained 40% over the five-year period. However, the Elliott Wave Principle reminds us that up cycles (and down cycles) don’t continue forever.
The emerging new carry trade (funded by low U.S. interest rates) is part of the asset strength and U.S. dollar weakness since March 2009. Because the Federal Reserve is content with short-term interest rates at low levels until after a recovery begins, it seems unlikely that the carry trade in U.S. dollars will end due to higher rates. But, recall that the Japanese didn’t end their carry trade in 2008 by raising interest rates, either. Instead, the market decided when the carry trade was over as the EUR/JPY crashed 33% over 12 weeks in mid-to-late 2008, giving back over five years of gains in less than three months.
When the U.S. dollar begins to rally, it will likely signal the end of liquid markets. The global financial system is in a punch-drunk state right now, and another crisis will shut off funding for carry trades, stock and bond issues along with commercial paper. The U.S. government and Federal Reserve may attempt another round of bailouts, but populist backlash may prevent or at least delay this attempt. Calls for an audit of the Federal Reserve, President Obama’s declining popularity and Main Street’s belief that bailout money is better spent by consumers than the government are all indications that a TARP II or another AIG-type rescue would be met with stiff resistance.
The markets are likely to move faster than government officials, and keeping a close watch on impulsive declines in EUR/USD will provide us with early warnings. There’s little doubt that Ben Bernanke will attempt some form of helicopter drop of U.S. dollars. But there’s also little doubt that the speed of the market’s collapse will likely prevent him from trying it -- at least until after another wave of risk aversion is complete.
A chance reading of a book on technical analysis and the Austrian school of economics eventually led Jason Farkas, CMT, to Elliott Wave International. An Arizona State University graduate, prior to joining EWI Jason worked for 14 years as a futures, options and equity trader. Jason has been tutored by some of the best investment minds, including legendary trader Dick Diamond. You can read Jason's Weekly Insights regularly in EWI's intensive Currency and Interest Rates Specialty Services.