Carry Trade killing the Economy?

The "carry-trade" refers to a way that financiers and speculators make money.  The premise is that one can borrow a currency (or asset) that is priced at or near 0% and then use that borrowed money to acquire another higher-yielding asset (such as long-dated treasury bonds) elsewhere and pocket the difference.  With use of leverage one can make fantastic amounts of money.

While this might seem logical the market may move to extend this scenario that benefit themselves but can damage the broader economy. 

The risk of damage comes when speculators who control disproportionate leverage in the system move en masse to protect their Golden Goose.. for example back-channel pressures can be put on politicians, policymakers ... and we know how easy the masses are led when the media creates a lot of buzz to scare them. 

Over the last few years many people, from workers to Presidents, have been conditioned to believe that the Fed lowering rates will carry the key to economic salvation.  Despite the fact that our economy continues to stagnate in the presence of very low short term rates, the screaming continues for yet more Quantitative Easing by the Fed. 

I think this is because those who benefit from the carry trade know that this will take the form of further acquisition of US Treasury Bonds by the Fed (or monetization of the debt), which will keep longer-term rates low.  And lower rates will permit more carry-trade bets. 

The knock-on effects of this ripple outwards:

• Distortions in the bond structure make weak economic policy look healthy instead of ill-advised, at least in the short-term.  This may solve temporary issues but enables further expansion of the debt... sort of like getting another credit card with a teaser rate that enables someone who is maxed out to transfer their balance and avoid paying the balance, for a short time.  If they are irresponsible then they will see the freed-up card as new money for further spending and feel 'wealthier' as a result. If more treasuries can be issued for low rates then the government may borrow and expand more since their models of relative cost are skewed by artificially low rate assumptions. 

• Race to devalue.  The currency tends to devalue since an explosion in money supply is required for monetization to proceed.  Competitor economies follow suit so as to prevent their currency from appearing to appreciate, even if it wasn't trying to appreciate.  This is because a currency that rises relative to others (or stays even while others fall) has their exports undermined.  If your foreign competitor is able to price their equivalent product lower than yours because their home currency weakened relative to yours, you both may have the same profit margins but not the same sales since buyers will go to your competitor first and you only as a last resort.  That can kill your business very fast, and governments know this so their central banks try to keep their devaluation rates more or less in the same ballpark as their export markets...  if they can.  If they fail, then that sector ceases to play a role as a job creator in the home market and the country becomes a net importer. 

• Inflation for real people becomes a problem.  In the presence of a flood of digital dollars that are printed to monetize the debt and keep rates low (which benefits further carry-trade activity), the price of real stuff appears to rise.  This is what we experience as inflation.  One extreme example is to imagine what would happen if you and everyone else in the world won the lottery... fantastic!  But who would staff the grocery stores?  The fuel stations?  The movie theaters?  No one.. at least, not at present wages.  The price of everything from apples to cars would go up to reflect a new wage structure to attract labor.  Shortly after 'winning' the new minimum wage would rise to thousands of dollars per hour, but people would still struggle to make ends meet since the cost of living would also be very very high.  Printing done to monetize the debt and permit the carry trade is causing the price of real stuff to rise at rates to levels not seen in many decades, if ever in this country. 

All of this is what we call digging a deeper hole for ourselves.  This adds undue risk to the economy since capital allocations may freeze up, preventing formation of new business, while players who otherwise should be liquidated are protected and receive the lionshare of rewards.


Will it end?

Of course.  No economic paradigm lasts forever and this situation will end.  Whether the end is sharp and sudden or slow and measured remains to be seen.  The price of metals is rising at a steep rate, as is most every other commodity, reflecting revaluation as dollars flood the system and find safe haven in real stuff.  I think the odds of a catastrophic end rise the faster the digital printing... and we are printing at faster and faster rates to keep ahead of a declining international bond position.  

 

What should I do?
 

It's easier to swim with the tide than against.  But if you time the turn wrong you could be swept out to sea.  Be adventurous but safe. 

 

Don't go all out.  Diversify just a part out of dollar assets and into real stuff, oil, metals, land, whatever.  I've had a fun turn playing a bit of the carry-trade too, playing currency pairs on Forex.com, but be careful there and practice with small amounts first as the leverage will wipe you out if you get greedy.  

 

Just remember the dollar is king but kings can topple, and the aftermath is often not pretty.  But for the time being figure out where the bets are and choose those that suit your risk tolerance, i.e. physical metal if conservative or highly-leveraged currency pair bets if you like to stake high. 

And for god's sake don't look to CNBC, Fox Business and the like for advice.. if anything use them for a pulse check on which cliff the herd is running off to next.