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The New Virus on the Street

The unprecedented growth in asset prices, before the October 2008 collapse, was funded in substantial measure by the yen carry trade . A zero interest rate policy of the last decade, pursued by the Bank of Japan, led ultimately to the re-emergence of Japanese industry but also came with collateral damage. Hedge funds and other investors borrowed heavily on the yen, at negligible interest rates, and invested in US treasury with a clear 4-5% spread. They also placed punts on a diverse array of asset classes such as Icelandic bond-markets; global currencies; Dubai real-estate and emerging market stocks. They enabled the funding of large acquisitions and basically drove asset prices truly beyond what fundamentals could justifiably support. A crippled Japanese banking system and a continuing perception of zero interest rates to support a weak yen policy, hedged all downside risks. However, the Bank of Japan eventually hiked interest rates and the currency strengthened against the dollar leading to an unwinding of positions, a subsequent reversal of the carry trade aiding the collapse of asset prices. History now seems to be repeating itself with the US dollar replacing the yen as the funding currency that would enable this.

The dollar carry trade is taking roots based on a weak banking system that allows for a low interest rate regime, perceptions of a crippled currency that offers modest risk in exchange rate fluctuations and numerous opportunities in what were undervalued and now rising asset classes. The Japanese government too recently indicated that it is not overtly concerned by the rise of the yen and will not intervene in the forex markets to support the dollar. This only encourages investors to sell the greenback against major currencies.

The most visible impact has been in the rise of gold prices which increased by 45% over the past 12 months and the jumping of stock markets in Asia (with China and India leading the fray) as punters borrow heavily in dollars at low interest rates (and perceived risk) and acquire assets across the globe. With growing deficits in most economies, sovereign bonds are understandably an unattractive option and consequently the dollar carry trade, (unlike the previous yen carry trade) is likely to target non-government asset categories. Here, prospects present themselves by an improvement in global risk appetite due to a recovery in the global economy and the reality that the attraction of the dollar is now much lower in terms of relative yields. With government bonds no longer an investment alternative, the consequential impact on private asset classes will be more forceful. Clearly, there will be more money chasing lesser options than there was when the yen served as the facilitating currency.

Over the course of the next few months it is possible that US banks may announce further losses. This may lead to an inability by the US Federal Reserve to effect an exit strategy for its massive impetus providing a further impulse to the dollar carry trade, at least in the coming two years. In a way, a sort of global revolt seems to be taking shape against the dollar with several central banks silently restructuring their currency reserves. The once mighty dollar no longer remains a safe haven and a store for value, a role it adequately fulfilled for a greater part of the past century, pushing central bankers to examine other options including gold, the yen and the euro.

In the fullness of time, however, as the US banking system begins to mend, consumer demand hardens and the US economy returns to a firmer path of recovery, the Federal Reserve will harden interest rates, prompting an unwinding of the dollar carry trade. Punters will then sell asset holdings across the world leading to a correction in prices. Clearly the extent of the correction will depend on how long the carry trade is allowed to continue. Leaving it too long will create asset bubbles that will burst, taking the global economy a full circle. This would be a financial disaster second time around.

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