Policy Watch Carry-Trade*
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By Carlos B. Cavalcanti @ ResearchGate March 15 2018 When the Federal Open Market Committee (FOMC) meets on March 20 and 21, deliberations will focus on a widely-expected increase in the benchmark Federal-funds rate given the factors that support such an increase. Less attention will be given to the impact of this increase on a popular trade, buying emerging market assets and exports using the U.S. dollar.2 The case for raising benchmark interest rates appears solid. Employment growth has been strong for a while and inflation is rising. Over the last seven month employers added an average of 200 thousand jobs per month3 and the consumer price index (CPI) printed at 2.2% in February (data released on March 13), up from 2.1% in January (Figure 1) -- above the Fed’s 2.o% target. Expectations of increasing inflation were already reflected in the rising gap between yields on 10-year nominal and 10-year inflationprotected Treasury securities (Figure 2). Figure 1: Consumer and Producer Price Indexes, 2017-2018 (Annual % Change) 3.5 3.0
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[email protected]. 2) The U.S. dollar accounts for an estimated 40% of global invoices. 3) Over the last three months the unemployment rate has held steady at a 17-year low of 4.1%.
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Figure 2: Difference in Yilelds Between 10-year Nominal and Inflation Protected Treasury Securities, 2017-2018 (%) 2.20 2.10 2.00 1.90 1.80 1.70 1.60
While the evidence of strong aggregate demand growth is clear,4 signs of sustained economic growth are less robust. A case in point are labor productivity data. The data shows that labor productivity growth has consistently been rising at a slower pace than output and, more recently, below the stride of unit labor costs (Figure 3).
Figure 3: Labor Market Indicators for the business sector 2015-18 (% change from corresponding quarter in the previous year) 5.0 4.0 3.0 2.0 1.0 0.0 -1.0
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Recent data shows the U.S. federal budget deficit increasing by almost 15% in February reaching $216 billion, up from $192 billion the same month a year ago. 4)
The drive to purchase emerging market stocks, bonds and currencies in recent years has been supported by the U.S. dollar’s slide5 (Figure 4). Using a strategy known as the carry-trade, investors borrow in a currency where interest rates are relatively low–such as the dollar or the euro–to purchase imports or higher-yielding assets in another currency. Traders pocket the difference between the two yields, and the trade can be especially profitable if the price of exports rises or the borrowed currency weakens. Figure 4: US$ Trade-Weighted U.S. Dollar Index, 2015-2018 135.0000 130.0000 125.0000 120.0000 115.0000 110.0000
The dollar’s 6.7% slide over the past 12 months has made it the preferred funding currency of many investors, leading analysts to predict that going forward the U.S. dollar would become the main source to fund higher-yielding activities in emerging economies. Concerns, however, over the U.S.’ shift toward a more protectionist trade stance are raising uncertainty about these trades by clouding the outlook for both the U.S. dollar and its emerging-market counterpart currencies, especially currencies of countries being targeted by the U.S.’ foreign trade policy.
Although this slide appears to have been interrupted over the last few weeks because of the changes announced in the U.S.’ trade policy. 5)
Conclusion. The FOMC is expected to raise the Federal-fund rate by another 0.25% at the conclusion of the March 20-21 meeting to the range 1.50 to 1.75%, up from the 1.25% to 1.50% range (Figure 5). The Fed’s drive to raise U.S. interest rates will, however, add to existing trade tensions by leading carry-trades to be unwound. Export-dependent emerging economies will suffer due to a retrenchment in global trade as a result of the United States’ more protectionist stance. The trade policies currently emerging from Washington, as well as a more hawkish monetary policy begging to be pursued by the Fed, will contribute to a slowdown in global growth.6,7 Figure 5: Effective Federal Funds Rate, 2017-2018 (%) 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80
The direct impact of recent tariffs on the U.S. imports of steel and aluminum, as well their cascading effects, such as tariffs imposed on U.S. exports by other countries, are still unknown. Other factors appear to be at play in the widening of the U.S. trade deficit, which reached $56.6 billion in January, up from $53.9 billion in December -- the highest trade deficit in over nine years. 7) Meanwhile, OPEC appears to be breaking into two camps after more than a year of unity around the aim to reduce a global oil surplus and raise oil prices. On one side is Saudi Arabia, which wants oil prices at $70 a barrel or higher, and on the other is Iran, which is striving to keep prices around $60. The split is driven by differing views over whether $70 a barrel push U.S. shale companies into increasing production, leading oil prices to crash. Iran wants OPEC to work to keep oil prices around $60 a barrel to contain shale producers 6)
