Which currencies should you be watching now?

The future behaviour of the yen and the Swiss franc will give strong clues about what is going on in the Carry Trade. It is worth just spending a few words expanding that point.

Currencies to watch: carry trade favourites

Imagine borrowing one million dollars denominated in either the yen or the Swiss franc. The effect of borrowing the yen or the Swiss franc is negative for that currency. You then use the borrowed money to buy an asset denominated in another currency, possibly a high yielding currency such as the New Zealand dollar or the Canadian dollar. The effect is to add strength to the value of the purchased currency. Success of that trade emboldens other investors to do the same and so the currency in which your loan is denominated weakens further and the currency purchased strengthens further.

The Achilles Heel of the Carry Trade is the high leverage you can't take a long view on a highly leveraged investment because even a modest reversal can trigger very big losses. If the currency in which the loan is denominated appreciates, your investment position deteriorates; more so if the value of the purchased currency deteriorates. It's a double hit, exaggerated by the leverage. If you decide to close your position, selling the asset will add to the downside pressure on the currency being sold and the repayment of the loan will add upside pressure to the currency of the loan being repaid. Other investors will see the deterioration and be forced to close their positions. As the stop losses are hit, the scale of activity accelerates, the exits get crowded, the rest we leave to your imagination. Going forward, it is going to be important to monitor these low interest rate currencies.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Currencies to watch: dollar reserves

The dollar, as measured by the US dollar trade weighted index, hangs on with its fingernails to a level which, if breached, could see it cascading downwards.

Sovereign wealth funds are funds made available from the huge foreign exchange reserves, predominantly dollar denominated, that are thought to be destined for more imaginative investment solutions. China's recent $3 billion investment in Blackstone being one of those.

The long-term implications are two-fold: firstly, the "Wall of Money" story is colossal for asset markets. Secondly, the dollar should come under considerable pressure. If current account surpluses in oil exporting nations, China and India, etc., continue to accumulate at the current rate, sovereign wealth funds will increase from $2.5 trillion to $12 trillion by 2015, a long-term guarantee for future global liquidity, virtually guaranteeing endless asset price inflation. The other consequence will be downward pressure on the dollar because much of this money is currently invested in relatively short-dated US government bonds, the selling of which will undermine the strength of the dollar.

Jim Grant wrote in the Financial Times about Kuwait's recent decision to de-link its currency from the dollar. The danger is, he says, that other Gulf States may follow suit, particularly if it becomes obvious that Kuwait are benefiting from their action. A policy of stockpiling the greenback and US securities had reached a point that if they continued to pursue rampant dollar absorption, broad money growth would continue to run at 20% per annum, feeding through into inflation. The only cure, a slower pace of dollar absorption.

How this all pans out is critical for the global economy and asset values. Asset price bubbles exist everywhere. The situation has probably reached a point where the answer, whatever it is, will be destructive. It's all about the global liquidity and the slowing and eventual demise of dollar sanitisation. It is only a matter of time before the renminbi and other pegged currencies revalue upwards; in so doing, addressing global imbalances, eventually for the good but there will be some considerable wreckage on the way.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/