I worry about the carry trade

Remember, in a global economy with multiple currencies, or an economy with lots of price variation, the notion of a single “real interest rate” is tricky.  The standard Fisherian story implies real interest rate near-neutrality across a wide set of expected monetary policy decisions.  Say expected inflation goes up, the nominal interest rate goes up, and the real rate stays constant, except for a small liquidity effect.

But that story will not apply across the board.  If, for instance, you live and consume in Jakarta, and you do not hold a PPP theory of the exchange rate, as indeed you should not, well, borrowing in dollars just got more expensive in real terms (with complicated qualifiers depending on forward rates which in reality don’t predict future currency movements so well).  Or if the Fed lowers nominal rates, your real borrowing rate goes down, maybe by more or less the same percentage amount as the nominal rate went down for the Americans.

And if those Indonesians are optimistic about the performance of their own currency vis-a-vis the U.S. dollar, crikey! — their current real interest rates from dollar borrowing appear to be very low indeed.  And if we are considering the individuals who hold disproportionate shares of non-USD currencies, almost by definition they are overly optimistic about the non-USD currencies.

And there are yet further complications which the nice weather today prevents me from outlining (what if those Indonesians are the marginal investors and they push around the market price for the Americans?)

All of which makes the Fed’s job much tougher.  Here is the latest from Bloomberg:

Since the 2008 financial crisis, companies across emerging markets have been borrowing dollars and converting them into local currencies as part of a massive carry trade. This practice has helped U.S. dollar shadow banking go global as the effects of near-zero U.S. interest rates seep into all corners of the world economy.

That’s the main finding of a new report released Thursday by the Bank for International Settlements, an institution in Basel, Switzerland, known as the central bank for central banks.

The paper, co-authored by Valentina Bruno, a finance professor at American University, and BIS Economic Adviser and Head of Research Hyun Song Shin, serves as a follow-up to a report released by the bank in January that found firms outside the U.S. have borrowed $9 trillion in U.S. dollars, up from $6 trillion before the global financial crisis.

To be sure, we do not know how harmful these practices might be, or not.  Here is FT coverage of the same:

By doing so companies become shadow banks, financial intermediaries moving dollars into local economies. Note, manufacturers do not have to explicitly act like hedge fund managers. Simply depositing funds with a local bank will help it to extend credit to other customers, while buying local commercial paper provides funds to domestic businesses.

The realisation prompts further questions. If it becomes more expensive to borrow in dollars, because say China fears prompt less dollar lending, will the corporate carry trade stop? Will it matter if it does?

I simply wish to reiterate that, no matter how many times commentators cite the low rate of price inflation, there are risks on both sides of the Fed’s forthcoming monetary policy decision.

Here is my much earlier post on monetary policy and the carry trade.  Beware the too-rapid acceptance of the strict Fisherian equation!  Once again, we do not live in a representative agent world and furthermore the multiplicity of agents speak a variety of languages and use a variety of currencies.

Comments

Am I the first to say that I would not like Tyler to be my econ professor? His posts, even on basic economic stuff, are always so Straussian, as he likes to put it. Or, as normal people say it, "cryptic". Maybe he'd be okay at some communication classes. I cannot make heads or tails of this post.

You have to play chess to understand TC, a chess master. He is discussing a complex position that has chances for both sides, but dangers too that he is highlighting. That's real world economics, not like the cartoon economics some people whose name I won't mention practice (Scott Sumner).

I find the Scotts Sumner and Alexander and Steve Sailer to be perpetually brilliant. All their names begin with an "S". Weird, eh.

*With exceptions. They're wrong about 5-7% of the time.

T'would be nice to sniff their jock strap into perpetuity enjoying never ending bless as long as the clock keeps'a'tickin'.

Good point. If you're traveling at mach 10 like TC does, you both just roll down your windows and talk. But when one side is situated terrestrially, words seem to be spoken fast, furious and unintelligible.

I feel that what TC is insinuating is that, you know, the FED tremendously increased the supply of dollars and lowered interest rates tremendously as well: a recipe for tremendous dollar proliferation into a globalized financial system.

The more cryptic he is, the more self the student pours into him -- assuming they give him the credit of being a Harvard educated, GMU approved, NYT sometimes blogging professor -- and assume he is a genius. Its actually quite a neat trick. Never take a position and be exposed to being potentially horribly wrong -- nice contrast to Cochrane 'Hyper inflation is coming in 2009!" or Ferguson "Gays dont think about the future and Asians cant be American".

What's this about Ferguson?

Niall Ferguson caught some flak for using the old joke about Keynes and the long run. It wasn't known until recently that Keynes did want children but his wife had miscarried.

David Broder once said that if you were out of ideas for your column, you could always invent a presidential candidate. If it doesn't happen, no one remembers. If it does, you said it first. I think the same principle applies to economic and financial journalism. Invent some novel or heretofore not understood hazard, and the rest follows formula. Less sophisticated operators (Yves Smith) invent disaster scenarios. Less subtle operators (Nassim Taleb) add excess trumpery ("ludic fallacy").

I know I'm not grasping all the nuance and complication in the post. But isn't one of Tyler's main messages here something like:

"People all over the world have come to depend directly on low US interest rates. A Fed hike will have a truly unpredictable global impact. So don't be so sure you know how it's going to unfold, Mr. Smarty Pants."

I really like Tyler Cowen. I come here a lot because there are interesting things to read, and the comment forum is diverse and not just an echo chamber.

But, Tyler needs to work on his writing. It's not Straussian, or cryptic, or filled with hidden meaning. It's unclear, florid, roundabout, even a bit pompous. I just comes off as immature. Complaints like this are a constant around here, and he would do well to take that feedback seriously.

Even emulating Alex's style would be a step in the right direction.

"I just comes off as immature."

Critique someone's writing, and it's certain you'll mess it up and look stupid.

Obviously that was supposed to be "It just comes off as immature."

No, no, it's ok, we understand what you wanted to say. It's called a "Freudian slip".

The irony was not lost on me...

I'd really like to understand what the risks are of waiting to raise rates at least until the US PL is back on its pre-crisis trend level and ideally until NGDP is back on its pre-crisis trend level.

Yes, I've heard about "reach for yield" but if financial institutions are undertaking too much risk to chase yield, that wound be an issue for prudential regulation, not a reason to depart from the monetary policy rule.

Are there any other risks of waiting?

The risk is that employees might get raises. That's the fear behind "labor market tightening" and the attention focused on the jobs reports.

Real wages aren't going to go up with monetary easing, foosion. They're going to go down.

With adequate enforcement, my price fixing scheme will work.

Too clever by half. Are you suggesting the Fed has a secret mandate to support global finance that takes precedence over their public inflation mandate and, rather than being the clueless rubes they appear to be, are actually diabolical geniuses?

It would be nice to think that the Fed at least spare a half a thought for the effects that their decisions have on the rest of the world. But of course, their actions should primarily (almost entirely, perhaps entirely) focus on the impacts on the USA.

Hasn't the philosophy always been "It's our currency, it's your problem"? Emerging market borrowers have agency. No one in Asia should be unaware of the risks, 1997 - 1998 wasn't that long ago.

All trade welcome except carry.

wtf is your tortured prose meant to convey?

"Remember, in a global economy with multiple currencies, or an economy with lots of price variation, the notion of a single “real interest rate” is tricky. The standard Fisherian story implies real interest rate near-neutrality across a wide set of expected monetary policy decisions. Say expected inflation goes up, the nominal interest rate goes up, and the real rate stays constant, except for a small liquidity effect.
But that story will not apply across the board. If, for instance, you live and consume in Jakarta, and you do not hold a PPP theory of the exchange rate, as indeed you should not, well, borrowing in dollars just got more expensive in real terms (with complicated qualifiers depending on forward rates which in reality don’t predict future currency movements so well). Or if the Fed lowers nominal rates, your real borrowing rate goes down, maybe by more or less the same percentage amount as the nominal rate went down for the Americans.
And if those Indonesians are optimistic about the performance of their own currency vis-a-vis the U.S. dollar, crikey! — their current real interest rates from dollar borrowing appear to be very low indeed. And if we are considering the individuals who hold disproportionate shares of non-USD currencies, almost by definition they are overly optimistic about the non-USD currencies.
And there are yet further complications which the nice weather today prevents me from outlining (what if those Indonesians are the marginal investors and they push around the market price for the Americans?)
All of which makes the Fed’s job much tougher. Here is the latest from Bloomberg:
Since the 2008 financial crisis, companies across emerging markets have been borrowing dollars and converting them into local currencies as part of a massive carry trade. This practice has helped U.S. dollar shadow banking go global as the effects of near-zero U.S. interest rates seep into all corners of the world economy.
That’s the main finding of a new report released Thursday by the Bank for International Settlements, an institution in Basel, Switzerland, known as the central bank for central banks.
The paper, co-authored by Valentina Bruno, a finance professor at American University, and BIS Economic Adviser and Head of Research Hyun Song Shin, serves as a follow-up to a report released by the bank in January that found firms outside the U.S. have borrowed $9 trillion in U.S. dollars, up from $6 trillion before the global financial crisis.
To be sure, we do not know how harmful these practices might be, or not. Here is FT coverage of the same:By doing so companies become shadow banks, financial intermediaries moving dollars into local economies. Note, manufacturers do not have to explicitly act like hedge fund managers.

Simply depositing funds with a local bank will help it to extend credit to other customers, while buying local commercial paper provides funds to domestic businesses.
The realisation prompts further questions. If it becomes more expensive to borrow in dollars, because say China fears prompt less dollar lending, will the corporate carry trade stop? Will it matter if it does?
I simply wish to reiterate that, no matter how many times commentators cite the low rate of price inflation, there are risks on both sides of the Fed’s forthcoming monetary policy decision.
Here is my much earlier post on monetary policy and the carry trade. Beware the too-rapid acceptance of the strict Fisherian equation! Once again, we do not live in a representative agent world and furthermore the multiplicity of agents speak a variety of languages and use a variety of currencies.
9 comments
- See more at: http://marginalrevolution.com/#sthash.8DtwmhR7.dpuf

Companies & countries bear interest rate risk.

The end.

Shadow banking? Moving money around digitally, not in brass-bound chests, for various purposes is now "shadow banking"? I guess I did some shadow banking last week and sold a bike to a fellow for half down and the rest next Wednesday.

That is called capitalism.

You sold actual productive capital by installment with the threat of taking back the bike if all the payments are not made.

The shadow banking system engages in lending your cash (paying you the super high rate of 3%, given savings at 0%) to me to buy food to eat (charging me 500%) and if all the "me"s go bust, they will force you to take only 25% back as a take it get nothing.

You have no recourse because there are no regulators protecting your savings, especially no requirement that shadow bankers lose a penny when they gambled away your money.

The banks that failed in 2007 were the ones who had not yet dumped the bad debt before the music stopped thus losing all money borrowed 24 hours at a time stopping the cash flow for which they charged a large fee.

The 2008 bailout was Fed and Treasury picking winners and losers who got money printed by the Fed or not - the winners were the money market funds who got to do retail banking without deposit insurance based on the promise that depositors would always agree to losing money on their deposits. If there is any justice, the money market fund that made that promise to get approval back circa 1969 was forced to cram down loses on its depositors. But not the other 10,000 that exploited the same deal without making the promise to screw over depositors. Talk about moral hazard. Four decades of legal require to cram down money market fund depositors flushed down the drain to prevent a one to three trillion dollar run on the shadow bank deposits - the retail money market funds. Remember, depositors in money market funds signed a legal agreement to lose money or have their money frozen if the debtors could not pay on demand.

What happened in 2008 was promised to NEVER happen by people like Milton Friedman because savers would never trust their money to bankers who made bad loans and money market fund managers would always maintain much higher reserves that the FDIC banks who lobby and get too small reserve requirements. I think Milton Friedman really thought people were very morally virtuous when it came to other people's money.

Cowen and Krugman and the Vulcan mind meld. http://www.nytimes.com/2015/09/04/opinion/paul-krugman-other-peoples-dollars-and-their-place-in-global-economics.html?ref=opinion

Right now the 3 most important currencies for international business have basically 0% interest rates. Maybe that number will decrease to 2 before too long, but 2 is still plenty! It doesn't seem like ECB or BOJ are going to raise rates any time soon. Draghi just announced more QE yesterday. I don't think the developing country carry trade is in any danger any time soon.

Should the Fed consider American geopolitical goals? OMG, your currencies are so crappy! Here's some aid from the IMF. America loves you.

The thing is at this point the FOMC has to balance any worry about the dollar shorts with worry about the moral hazard involved in catering to them.

Not to worry.

EMH.

"forward rates which in reality don’t predict future currency movements so well"

This is a really naive claim. The forward points have to equal the interest rate differential or there would be an arbitrage opportunity. Those points would predict the movements under uncovered interest rate parity, but there are many reasons to disbelieve that theory. The entire carry trade concept is based on the unpredictability of future spot prices. You collect the carry and accept the (hopefully zero mean) spot return.

Anyways, this post seems rubbish to me. If the Fed raises rates then the dollar will shoot up in value and some folks at the margin will want to hold dollars to earn that little bit of interest. The interest rate on Indonesian Rupia is 7.5%. All IDR/USD carry trades are long IDR and short USD and a 25-50 bps increase in USD rates doesn't affect that much at all. Perhaps some will shift to CHF, EUR, or JPY. Nothing monumental. There is no reason to think currency portfolios wont be continuous in interest rates. Small change in rates => small change in FX portfolios.

Suppose the Fed raises a quarter-point...but also goes to $50 billion a month QE?
I think monetary tightening is injurious, not prudent now. Could set off global recession.

I don't understand why people think the blog post is obtuse. It seems clear to me.

I will add - just to complicate things - that it is possible for one Indonesian to lend money to another Indonesian and denominate the loan in US dollars without a US dollar ever changing hands.

And with 300+ trillion in interest rate swaps and 200+ trillion in credit default swaps outstanding no one knows where the risk ultimately resides. That is a recipe for contagion effects and a melt down.

Comments for this post are closed