Bubble is building

Future bubbles Dollar carry trade

Concept

The concept of carry trade is taken from the arbitrage world where people looks for the risk less opportunity to make money although involvement of risk is not nullified in the carry trade however modus operandi is almost similar to arbitrage.

Here's an example of a "U.S.dollar carry trade": a trader borrows 1,000 U.S.dollar from a U.S bank, converts the funds into Indian National Rupee and buys a financial assets for the equivalent amount in India it may be bond stocks debenture etc. Let's assume that the investment in India pays 6.5% and the U.S. interest rate is set at 0.25%. The trader stands to make a profit of 6.25% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit more than 62%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar will fall in value relative to the INR, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

Events

The easy money policy from the central bank’s around the Globe created ample liquidity in the markets, especially near zero rate interest rate policy by US Fed created huge outflow of dollar from the US and over supply of Dollar resulted as the deprecation of Dollar with respect to all major currency and emergence of carry trade, in this trade people takes money from the us due to the negligible interest rate regime over there and park those money in the high return securities around the globe due to this Global markets have rallied "too much, too soon, too fast" this year. but a correction is inevitable once fed will shed this policy the rising inflation is the one important indicator of which forced the regulator to think on easy money policy although it will not happen right away, as a cheap dollar will still encourage investors to seek higher-yielding assets for a few more months however time is short for the people betting on liquidity driven asset.

Recovery of U.S. dollar which is traded at the year’s low is depend upon the rise in interest rate which will led the repatriation of US dollar , but only in "six to 12 months from now, not any time soon."A correction might occur, but the risk of a correction is more in the medium term than in the short term, but the time when the correction will come it will sharp and painful for the equity markets around the globe.

The economist repeating their view that the U.S. economic recovery will be anemic, subpar and U-shaped, which should decipher into worse-than-expected corporate earnings and macroeconomic indicators, eventually forcing asset prices down.

Such a correction will be delayed, however, by a prolonged period of low interest rates and fiscal stimulus.

Many analysts are in the opinion that the real economy will surprise on the downside, especially when the stimulus fizzles out, but on the other side we will have the effects of policies, especially monetary and liquidity, that keep asset prices levitating.

Money wheel

Loose monetary policies around the world has resulted in continuous dollar inflows into developing economies and emerging markets like especially in Asia, which are likely to grow faster than developed world for several years.

The challenge for emerging market countries like Brazil, India will be to implement effective policies to curb excessive capital inflows that have led to appreciation in their currencies, to curb the inflow Brazil has imposed Tobin tax on inflow. The depreciating dollar is creating the risk for the exporter. The solution is probably along the lines of capital controls but capital control is the toughest step for the capital deficit emerging markets. Here money is chasing their growth with objective to get more return in shortest time and creating volatility in their markets. This is the reason behind the imposition of tax on inflow by Brazil.

Impacts

The beginning of carrying trade has infused the liquidity in the financial and commodity market around the globe. Chase of U.S.dollar pushed the Gold, Crude at their highest levels in 2009 and same effect has observe in equity around the globe Brazilian market has gone up by 145% on strong dollar flow. Dollar index came down sharply to their year high 89.62 on 4th march to the year low 74.17 on 26th November and take pullback from there. In the next six month when economy will come on growth path then inflation will be the primary agenda for the fed and they will increase the interest to suck the excess liquidity from the market. Rise in interest rate will trigger the unwinding of dollar carry trade. The unwinding of trade will create volatility in the stock market around the world it can led to another stock market carnage in the emerging market because significant amount of fund by FII and hedge fund has been pumped into the equity markets during their up move.

FIG:Dollar index 2009

Unwinding the trade will create negative impact on the local currency and unusual depreciation of the local currency will be disastrous for the exporters and their profit margin will be impacted