What the rising cost of the carry trade means for your investments

Now that central banks in Europe and Japan are raising interest rates, the days of easy money trades look to be over. What do the rising costs of carry mean for asset prices? And, asks Richard Benson of Specialty Finance Group, what does it mean for your investment strategy?

By MoneyWeek

published 20 July 2006

in Features

Up until just recently the only bargains in the carry trade were achieved by borrowing at lower interest rates in the euro and yen. This can be risky, though, because of the uncertainty of exchange rates. Below is an example of what I mean:

Say a trader borrows 5,000 yen from a Japanese bank and converts the funds into U.S. dollars. He then purchases a bond for the equivalent amount, and this bond pays 5 percent or more (and the Japanese interest rate is set at 0 percent). Obviously, this trader stands to make a profit of at least 5 percent as long as the exchange rate between the countries does not change. But if the yen strengthens, this trader is easily wiped out.

Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. But if the U.S. dollar continues to fall in value relative to the Japanese yen (as in the example above), traders may become victims of their own greed and fearlessness. Transactions like this use a lot of leverage, so any small movement in exchange rates can result in big losses unless they are hedged appropriately. Surprise! Interest rates are now going up in Europe and Japan and the vast majority of central banks around the world are raising their cost of borrowing. The easy money trades are gone.

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The U.S. financial markets for stocks, bonds and commodities are greatly affected by the willingness of market participants to behave like traders by placing bets. These bets are based on the belief that there will be a continuation of some trend or theme in the market that will ultimately affect stock prices. Contrary to the message from Wall Street professionals who say "stock prices will only go up", I'm placing my bets on a declining dollar, a stormy end to the housing bubble, and a long-term bull market in commodities, particularly precious metals. However, except for owning physical gold and silver, I do not believe it's wise to place bets every day.

When the Federal Reserve Bank cut interest rates to 1 percent, the cost of carry was ignored because it was insignificant. (At that time, borrowing money to gamble on stocks, bonds and commodities was virtually free.) Today, with the Fed Funds rate at 5.25 percent and likely to go up, the cost of carry is much higher and most speculators are paying more than the Fed Funds rate! To make money today, they must place bets on assets that are rising faster than interest rates otherwise they'll be eaten alive by the cost of carry.

The second quarter of 2006 (and so far in July) has been painful to anyone who "went long" by buying risky positions: stocks were down, emerging markets were crushed, and commodities had a very severe price correction that is still ongoing. Massive amounts of credit were extended to put on these speculative positions and while some air has deflated out of the credit bubble, there are still hundreds and hundreds of billions of highly-leveraged speculative positions in the markets. To date, only a small amount of the excess speculation has been drained away. Remember, when greedy speculators get carried away, they can literally be carried out of the financial market casino with empty pockets on a stretcher.

Obviously, if the price of an investment is going up, lenders supplying the credit will be willing to advance the interest charge against the increased collateral value. However, if the price of the asset is declining, some of the investment will have to be sold off to pay the interest. The lenders will then start sending out margin calls. Where does one get the cash to pay for the interest charge and any margin call? If you are forced to sell some of your investment just to pay the interest charges, chances are you're not the only one selling. So, if other speculators are selling, who's actually buying and what's going to happen to the price of the asset?

Rumor has it in professional money management circles that only a few speculators actually made money in the second quarter of 2006. If these same speculators shorted their positions instead, they would have generated a positive cash balance that earned interest and made money because the price at which they would have to buy back their short sale would have dropped below the initial price they paid.

The markets are beginning to wise up to the crushing cost of carry. Behaviors are beginning to change. Even managers of mutual funds have noticed that when stock prices are not rising, they can enhance their portfolio yields by increasing their cash position! (What happens when mutual funds are selling and no one is buying?) Commodity speculators on high-leverage have recently noticed they have to be very nimble on the long side and get in and out quickly before they are crushed. Buy and hold strategies are expensive, frequently painful and sometimes career-ending.

MoneyWeek is written by a team of experienced and award-winning journalists, plus expert columnists. As well as daily digital news and features, MoneyWeek also publishes a weekly magazine, covering investing and personal finance. From share tips, pensions, gold to practical investment tips - we provide a round-up to help you make money and keep it.