A (little bit) further evidence on the dollar carry trade

Heiko Hesse, using an econometric tool known as Dynamic Conditional Correlation, finds that the co-movements between the dollar and several asset classes has increased lately. I don't know much about autoregressive conditional heteroskedasticity (the framework from which stems this tool), but in my understanding, this just barely confirms that 80%-90%+ correlations between the dollar and these asset classes are, as suspected, both significant and much higher than they have in the past. (Simpler analysis as in my previous post showed correlations were higher but only very likely to be statistically significant...)

What it does not, however, is state that these high (and higher than unusual) correlations are a definite proof that the dollar carry trade is a major culprit for the froth in risky asset prices. We are still looking for definitive evidence on that, and I'm afraid this is not going to come before regulators start asking banks to report the numbers.

Even more on the dollar carry trade

From "BarCap analysts", via FT Alphaville:

The size of carry traders is notoriously difficult to measure, and there is considerable speculation on their size based on very incomplete evidence. Consider, however, a measure of the classic incentive to put on carry trades — volatility-adjusted spreads. We use two such measures, the volatility-adjusted spread between AUD and JPY and the volatility-adjusted spread between AUD and USD. In each case, we divide the 10y yield differential between by one year implied volatility.
These measures do not encourage the view that carry trades would be put on in size . Whatever the incentives from the rate differentials, implied volatilities remain high enough to discourage carry trades. In both cases, the incentives are not only well below the peak, they are well below the average.

If anything, this suggests that the market may be overestimating the extent of carry trades now in place and underestimating the potential for carry trades to be instituted if implied volatilities pull closer toward historical norms and realized volatility.

Well excuse me anonymous BarCap analysts, but you are pretending to be more stupid than you actually are. The carry trade everybody's talking about is more about capital gains than about pure yield carry, and your measures are not adapted to this. These measures were useful when the carry trade was about shorting yen and going long higher yielding currencies (notably as you mention, AUD) using enormous leverage, hence the need to monitor volatility. The topic du jour is about borrowing dollars and going long low- or zero-yielding things like commodities, stocks or other low-yielding bonds and currencies, presumably with a much lower leverage. Volatility has become less important, but more to the point, AUD volatility is pretty much irrelevent to the debate.

A more interesting argument comes from David Rosenberg (I actually think he borrowed it, I saw that somewhere else recently):

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

More on the U.S. Dollar carry trade

Paul Kasriel believes that proponents of the dollar carry trade hypothesis do not have much evidence on their hands:

There is a lot of chatter that global speculators are borrowing greenbacks at bargain basement interest rates and buying higher-yielding assets denominated in foreign currencies. Some have suggested that this dollar-carry trade is creating yet another asset-price bubble. Other than the fact that the U.S. dollar has been depreciating on a trade-weighted basis in recent months, where is the evidence for this dollar-carry trade? In other words, where is this alleged massive bubblicious U.S. dollar credit creation showing up? I will tell you where it is not showing up – on the books of U.S. commercial banks. In the 26 weeks ended October 28, 2009, loans and investments at U.S.- domiciled commercial banks have contracted at an annual (Devil’s) rate of 6.66% (see Chart 1).

Two remarks here: first, the fact that total loans are contracting does not mean that loans for carry trade purposes are contracting as well. It could mean that loans to the non-financial sector are contracting at an even lower pace than that of the total figure. Second, the top U.S. banks hold large amounts of FX and FX derivative exposure (see Reggie Middleton, subscribtion required). Some of this exposure may be off-balance sheet and thus may not appear in the Federal Reserve figures used by Kasriel and be a part of the carry trade story.

Roubini: "Mother of all Carry Trades Faces an Inevitable Bust"

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

(...) Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies.

 http://www.rgemonitor.com/roubini-monitor/257912/mother_of_all_carry_trades_faces_an_inevitable_bust