Friday, December 2, 2011

Blame Dollar Carry Trade

Financial press looks like blind wise men from the old story: when asked to describe and elephant, one said it was a rope, another one, a column, and a third one, a pipe. What to we see in press lately? European debt crisis, withdrawals from hedge funds, (hyper)inflation which can't ever materialize and intervention of Central Banks. And nobody can see an elephant in the room. Well, almost nobody.. Howard Simons of has this article and couple of others.

In short, in the last couple of years, banks, hedge funds and anybody who wanted and could do it, borrowed dollars (cheap) and bought securities around the world with much higher yield. Underlying idea was that Fed is printing dollars like crazy, that dollar has nowhere to go but down and it looks like an easy and sure way to make huge money. Of course, people always forget that there is no easy and sure way to make money. Fast forward to July 2011. Hedge funds started big attack on Eurozone sovereign debt. There were lots of publications in press how this debt is unsustainable and why some (or many) countries will be forced into default. I don't think all of this press was paid for by hedgies. But significant part of it certainly was. Result: yields on debt are up, but, what is more important, Euro fell more than 10% related to dollar. And this is the level of currency fluctuation which kills carry trade dead. I don't know all the details, they are mystery even for SEC, but it looks like the main reason for MF Global  collapse.

I'm afraid, that MF Global collapse is just peanuts comparing to the size of the problem. We are talking hundreds of billions, if not trillions, of dollars. Coordinated intervention by Central Banks tells me that trillions is a better guess. And dollar carry trade is not restricted to Europe.

We are not out of the woods. Eurozone politicians still don't understand the size of the problem. The other parts of the world are still to find out.

Commenting on the action of Thanksgiving week, I wrote that it looked like margin call action. I think I can further qualify it as a margin call related to dollar carry trade unwinding. Some people think that this problem is not related to US. After all, Europe is only about 10% of US exports. Yeah, right. And one collapse of a big European bank can easily topple all world financial system. If dollar carry trade to unwind fast, we will import huge, massive deflation from Europe.

What investment decisions can be made? The only thing I can think of is to increase cash cushion and hope for the better. Big bank collapse is not a tradable event, everybody would suffer, the question is: how much.

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