With near-zero US interest rates and easy funds readily available, investors have borrowed huge sums of money in dollars to purchase higher-yielding assets overseas in carry trades to achieve better returns.

Increased carry trade in the dollar would likely result in further declines in the dollar, which has fallen 7 percent so far this year against a major currency basket , weighed down by increasing risk appetite and low interest rates.

Estimates from Pi Economics suggest the dollar carry trade may have reached $250 billion to $550 billion in the first half of 2009. At the height of the yen carry trade, transactions were said to have hit $1 trillion, accumulated from 2004-2007.

US carry trades are expected to keep growing as the Federal Reserve has essentially provided a blueprint of its policy intentions on low interest rates, which should help keep volatility low. Japan’s carry trade thrived for years not just because of low rates, but because of low volatility.

“The fact is that the Federal Reserve is not going to hike interest rates any time soon,” Franulovich said. “Even when they do hike rates, it’s almost impossible to see the US returning back to 5 or 5.5 percent fed funds rate where they are competitive with the rest of the world.” Franulovich said the interest-rate differential would be the “ultimate long-term factor” that will sustain the dollar carry trade in the same way the yen carry lived for 12 years.

Yen carry reversal in late 1990s

Analysts did concede carry trades could reverse any time. That happened in the late 1990s during the Asian crisis when dollar fell against the yen from a peak of 147.63 yen in August 1998 to a low of 111.53 yen by October of the same year. As soon as the storm passed, investors resumed selling the yen.

Tim Lee, founder of economic consulting firm Pi Economics in Stamford, Connecticut, believes the yen carry trade peaked at the onset of the credit crisis in the summer of 2007. He estimated these yen trades to be $1 trillion, a figure derived from adding up Japanese banks’ foreign assets, cumulative short-term net foreign lending from Japan’s balance of payments, and the net speculative position in yen futures at the Chicago Mercantile Exchange.

Typically, a carry trade involves lending by domestic banks to finance high-yielding bets overseas, so this should increase local banks’ foreign assets.

Lee said of the $1 trillion yen carry piled up in three years, about $600 billion has so far been unwound. The unwinding has carried on gradually even as global market risk appetite has improved over the past eight months.

“The implication is that a declining yen carry trade has been replaced with a burgeoning dollar carry and this is consistent with early indications from US banking statistics,” Lee said.

The general assumption is that the dollar carry trade gained momentum in the third quarter of this year as risk appetite rose and the cost of benchmark three-month interbank dollar funds fell below those of the yen.

How big is it?

Lee said the size of the dollar carry trade can be inferred from the increase in net foreign assets of the US financial sector – the simplest proxy measure of carry activity. He said this measure shows an increase of over $500 billion in the first and second quarters of 2009.
Another way to measure the dollar carry trade is to calculate the net claims position of foreign banking offices in the United States. A large proportion of these trades seemed to have taken place overseas through foreign banks that have borrowed dollars from their US offices. These net claims position was up $250 billion in the first half of the year.

Whether the current dollar carry trade could exceed its yen predecessor remains to be seen. These transactions have seemed hefty because all asset markets have become tightly correlated, a condition that did not exist during the life of the yen carry trade.

“There’s no difference between owning gold, stocks, foreign currencies ex-dollars because all are tightly correlated,” said David Gilmore, a partner at FX Analytics in Essex, Connecticut.
Because of that, he said, if global conditions change, that trade may be unwound rapidly, and in such situations, “the impact is usually very large.”

Under pressure

The dollar touched as low as 84.83 on November 27, the weakest in 14 years, spurring speculation Japan would intervene to curtail gains in its currency.

The dollar has depreciated 7 percent against the euro, 4.5 percent against the yen and 13 percent versus the pound in 2009. The IntercontinentalExchange’s Dollar Index, which tracks the greenback against currencies of six major US trading partners including the euro, yen and pound, has fallen 7.3 percent in 2009.

For the week ended November 27, the greenback fell 2.6 percent to 86.57 yen, the fifth consecutive weekly decline. The dollar and yen rallied against the Australian dollar and the South Korean won as Dubai’s attempt to delay debt repayments spurred investors to sell higher-yielding assets funded with the currencies.

“The market has re-priced the risk it is willing to sit with, noticeably against the dollar-yen,” said Lane Newman, director of currency trading at ING Financial Services Corp. in New York. “My sense is that damage has been done, the market being not as liquid as it has been in a long time. It is going to trade in this way and when the market has to do something it’s going to be very, very ugly.”

The Japanese Finance Minister Hirohisa Fujii said he will contact US and European officials about exchange rates if needed, signaling his growing concern that the yen’s ascent will hurt the economy. The Bank of Japan checked rates at commercial banks in Tokyo, seen as a type of verbal intervention, Kyodo News Service reported.

Japan hasn’t sold its currency since March 16, 2004, when it traded around 109 per dollar. The Bank of Japan sold 14.8 trillion yen ($172 billion) in the first three months of 2004, after record sales of 20.4 trillion yen in 2003. Japan last bought the currency in 1998, purchasing 3.05 trillion yen as the rate fell as low as 147.66.

“If the dollar-yen falls below an 85 level the odds of intervention would rise materially,” said Vassili Serebriakov, a currency strategist at Wells Fargo & Co. in New York. “Clearly this is somewhat of an unfolding of events given previous signals of a strong yen policy but a strong yen will become a problem for the Japanese economy.”

The greenback fell on speculation the Fed will trail other central banks in increasing borrowing costs after policy makers said in the minutes of their November meeting that they will keep interest rates near zero for “an extended period” as long as inflation expectations are stable and unemployment fails to decline. The minutes, released on Nov. 24, also said the dollar’s depreciation was “orderly,” indicating policy makers are willing to tolerate a weaker US currency.