The Great Recession: The Threat to the Carry Trade

The access to capital through the Repo market has been a driving force in the financial market come-back in 2009. Some of the proceeds are also used to acquire financial product in the Emerging Nations and as a result also appreciates their currency as well.  This however ultimately becomes problematic for the recipient country of the Carry Trade inflows.

For example, Brazil as a recipient country of the investment flows now finds itself with the winner’s curse of having access to cheap capital that drives wealth creation though with the added burden of having to export in the face of an appreciating currency. Hence, these countries who rely on exports to drive economic growth find themselves considering a currency intervention to cheapen the terms of trade.  This in turn is a threat to the continuation of the Carry Trade because at some point the unwinding of the trade would require the sale of Brazilian assets and the repurchase of more expensive dollars to retire the loan.

Another threat to the continuation of the Carry Trade occurs at the source of the Carry Trade funding.  If indeed the Fed EXITS meaning the end to near zero cost funding this would drive up the cost of the carry trade and cause it to unwind at least from Dollar sources of funds.  However with the developed world generally in economic distress the funding of the carry trade could easily switch to for example Japan who has indicated low rates will prevail for as far as the eye can see.

But what the Carry Trade has done for the economy on a positive note is make capital available to firms that directly reach public capital markets and reduce the cost of new investment which no doubt is behind the recent tech spending that is making a contribution to reviving the economy.

But aside from the positive influences of the carry trade, the economy is still mired down in the key drivers of the Great Recession.  Consumers are over indebted and are seeking to repay rather than extend debt and banks are contracting lending at record pace.  This change in their behavior from being upside down prevents recovery. Even government largess in the form of spending and income transfers have reduced the GDP multiplier to near zero, and the Fed’s ability to ramp up bank extension of credit has been greeted with a money supply multiplier that is negative.

So basically the efforts to deleverage an over indebted consumer sector has resulted in meager reductions of consumer debt well below the additions to government debt so the total country indebtedness grows.  So the upside down private sector is driving the government including the central bank into an upside down state.  The Fed’s upside down potential follows from its purchase of risky private securities as a result of their financial market price support and as a result of it facilitating some of the Investment bank M &As.  That is it financed a package of Bear Sterns assets as a condition of the JP Morgan Chase acquisition has had significant private credit loss exposure.  (See for example, IMF Working Paper, The Federal Reserve System Balance Sheet: What Happened and Why it Matters by Peter Stella).  The worse are in a vehicle called Maiden Lane, LLC and recently a court order forced the Fed to reveal those assets.  Of course the market then sought to value those assets and concluded they are worth no more than 60 cents on the dollar.  Furthermore the Fed owns $1.25 of RMB Securities that are taking losses which are likely to exceed the Fed’s stated capital of 2% of assets.  The day could come when the market realizes the Federal Reserve Banks are insolvent (Upside Down) and that could cause a run on the Dollar.  An insolvent Fed is a balance sheet statement but it would not impair the ability of the Fed to meet its financial obligations as the printing press is under its control.  However the shock factor could cause net capital flight from Dollar assets. So the Perfect Storm continues and the government’s efforts to blunt those forces and create upward momentum in the economy are held back by the deadweight cost of existing and growing government debt. This a subject that will be highlighted in the Sovereign Risk series.

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