Funding Carry Trade w/ $, Currency of the Doomed

It is common knowledge by now that next to nothing is going right in the US economy. America's various debt orgies have brought it little but additional misery. Deficit lovers thought they could revive this wasteland by borrowing even more humongous amounts to cure ills caused by borrowing too much in the first place. In the end, nobody feels sorry for America--except perhaps Martin Wolf, who's become something of an apologist for Anglo-Saxon orthodoxy as of late. It's justice served: if you act foolishly, you fully deserve what's coming to you.

As if we needed even more proof of the descent of this economic wasteland comes even more news of its pointless existence. Briefly, the "carry trade" is one of the most basic plays in foreign exchange. One borrows in a currency charging lower interest--the "funding currency"--and lends in a currency yielding higher. In the past, nearly zero-yield Swiss francs and Japanese yen were the favourite funding currencies of foreign exchange traders. However, a comatose US economy has meant policymakers keeping similarly low interest rates Stateside.

Voila! The dollar is now becoming a funding currency of choice. Not only is it yielding next to nothing, but limited expectations of the US escaping the ambit of its self-inflicted and wholly deserved financial ruin mean many are willing to use the dollar as a cheap and stably moribund funding currency. That is, a funding currency is best provided by an economy with few growth prospects that may require interest rate rises to cool down. Reuters explains this latest piece in the puzzle of American decline:

While the dollar is still far from surpassing the Japanese yen and the Swiss franc as the world's funding currency of choice, investors are no longer rushing to buy the greenback as a safe haven any time trouble erupts worldwide. While not inherently bad for the dollar, being a funding currency is a sign of investors' disenchantment in U.S. economic growth and return potential. In time, countries with funding units face difficulty attracting foreign investment, further eroding economic prospects and the attractiveness of their currency.

On Thursday for example, the dollar sold off against both yen and Swiss franc after a report showed factory activity in the U.S. Mid-Atlantic region unexpectedly contracted. Both currencies are lower yielding than the dollar, making them better funding options. Until recently investors would have sold them and bought back dollars after the headlines.

The move on Thursday "was not a flight into U.S. dollars, but a flight out of the dollar," said Douglas Borthwick, a managing director for trading at Faros Trading LLC, a forex execution firm in Stamford, Connecticut. "If the dollar is no longer seen as the destination for the 'flight to safety' then the market will use it as the currency to be short against high-yield trades given it will shield them the most from adverse moves," he added. "Thus it would become the funding currency of choice."

In the forex markets, a funding currency is used to finance so-called carry trades. A carry trade involves borrowing in a low yielding currency to buy higher yielding assets elsewhere. High liquidity, low yields and low volatility are all desired traits in a funding currency. The Japanese yen fit all of those attributes for years, making it popular for trades involving the Brazilian real, the Mexican peso and the Australian dollar.

"There's a possibility the dollar will be just like the yen a couple of years ago," said Dean Malone, a currency director at Compass FX in Dallas, Texas, which sold U.S. dollar versus Swiss francs on Thursday. "With yields these low, there's simply very little appreciation value in the dollar," he said. "Until we turn the corner, until employment picks up and the Fed decides to start raising interest rates, markets will keep looking for higher returns elsewhere. And the dollar may be used to help fund those trades..."

Some analysts are cautious however on reading too much into the dollar's recent trading behavior. They note that when taken into account the implied volatility and yield spreads across currency pairs -- key measures to help gauge a carry trade efficiency -- the dollar doesn't stand out as a funding unit.

Analysts at RBC Capital Markets compile a "carry value barometer," which ranks funding currencies, using option prices and measuring yield spreads adjusted for volatility. According to the bank's latest reading the Canadian dollar is now the best funding currency, in particular for trades involving the Australian dollar, South African rand, the Brazilian real and the Turkish lira.

In comparison, the dollar ranked between the 4th and 6th best option among 8 currencies, involving the same pairs. "No doubt the low yields are hurting the dollar," said Todd Elmer, a G10 currency strategist for Citigroup Inc. in New York. "But I'm not sure about selling it to buy the yen and the Swiss franc for some potential marginal yield gain."

I don't need to spell out what it means when some traders view USD as a better funding currency for the carry trade than the yen given the state of the Japanese economy for the last two decades. We knew it all along: America stinks and so does its currency. Long live the carry trade! I think it's time I took a punt on AUD/USD...