Carry Trade Coming Back?

Financial markets look to be rebounding after their huge drops in the last couple of weeks. Markets have seen an uptick in value and, and recent news only seems to support that trend. The primary effects of this movement on the foreign exchange market have been twofold: providing the Fed with justification to slow down the easing process and giving Mrs. Watananbe the ability to resume the carry trade.

Let’s look first at how the financial markets have returned to a relative state of calm. The four biggest US banks borrowed $500 million each from the Fed’s discount window yesterday. None of the four actually need the money, but the act is a symbol of trust in and acceptance of the Fed’s recent decision to lower the discount rate. Bank of America also took a new $2 billion stake in Countrywide Financial, the nation’s biggest lender of home loans, a catalyst that drove down corporate bond risk and drove up stocks. Once thought to be on the verge of bankruptcy, Countrywide appears to have survived the crisis, signaling hope for the larger economy. Looking at the broader equities market, the VIX index feel even more yesterday, now sitting more than 40% lower than the highs hit last week.

All this good news might indicate that the Fed doesn’t have to ease rates to the extent that futures traders have priced in. And indications from US central bankers point to the Fed not really wanting to lower rates just now (the moral hazard problem). The Fed has a number of different options as to what it could do in September and October, but it has to realize that the credit problems are still far from over. Commercial paper is still being ignored to a ridiculous degree, and if a wide scale easing program is not implemented, then we could see the problems of Wall Street spread to Main Street.

A spread to the wider economy is not out of the realm of possibility. Layoffs in mortgage companies are coming, and the big banks are already shutting down their subprime units. More troubling is what happens to mortgage rates if the Fed keeps rates steady. Adjustable rate mortgages are set to be re-priced next month, and with credit conditions as they are now, we will see consumers swamped with enormous debt service bills. Consumers are the engine of the US economy, and any slowdown in that sector because of higher bills could be disastrous. That said, if the Fed keeps rates steady, it would also be bullish for the US dollar in the short-term. As corporate profits shrink and equities markets decline, we would see a strengthening of the dollar’s safe-have bid, and USD/JPY, especially, would see the bottom fall out.

But with the stock market reasonably strong and most market participants sure of a Fed funds interest rate cut, the US dollar is seeing some capital outflow and so is the Japanese yen. The dollar-yen hit 117 last night, and the carry trade seems to be returning. Mrs. Watanabe saw in the recent drops the same buying opportunity that hedge funds proclaimed (and quantitative funds have made back most of their losses this week). We should see at least two rate cuts this year in the United States and that should generally prove bullish for the carry trade. But as always, be careful.