Thursday, July 16, 2009

Carry Trade Poses Problems For Green Back

Currency Carry Trades were very popular, highly profitable and predictable trading strategies that many global macro hedge funds put on. But late last year the carry trades failed as many currency hedge funds were caught on the wrong end of the safety trade.

The trades work like this:

Hedge Funds/Institutions borrow money in countries with lower rates to invest in those countries with higher yields, pocketing the difference, sort of currency arbitrage.

Using Dollars, Euros, and the Yen, to buy currencies in emerging markets like Indonesia, Brazil, and South Africa for example.

Again...very profitable for the most part over the last 3 decades. These type of strategies produced average annual returns of 21% in the 1980's, with out a single down year. In the 1990's they worked 70% of the time, the worst year on record so far was in 1992, when this strategy dove 54%. So far from 2005 to 2005, this strategy is up 16%. But since, the trade has taken it on the chin, most notably John Henry's Global Currency Hedge Fund, which has gotten rocked the last few years.

2008 was a bad year in general for carry trades, as you may have noticed investors globally fled to safety assets like the US Dollar. Speculators unwound this trade as most central banks cut rates to revive growth, which narrowed spreads.

So far this year, many hedge funds that are left have nearly doubled their returns as the dollar has dropped vs emerging market currencies, most notably because the safety trade of buying USD/Treasury Assets has to be unwound.

We are definitely in for a period of monetary expansion as the Government will do whats necessary to stave off a depression, which means continued printing of money. This will put further pressure on the USD.

This sets up the classic risk currency trade where you will sell dollars against emerging market currencies.

All in all its OK, the safety trade, like all profitable trades over shoot, spreads need to narrow and they have. The continued selling of dollars by hedge funds will effect further Treasury refunding.

If the USD losses reserve currency status? Then its a different story.

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