carry trades and how u r affected:
As the domestic currency of the nation falls in value due to the slowdown in demand, the cost of many goods in that nation begin to rise for two reasons:
First – investors move to protect the value of their wealth and shelter it against the fall in the currency in which their holdings are denominated. That is what is currently happening with the commodity markets. Those things which will tend to retain their value are sought out and purchased.
Second – weakness in the currency leads to a rise in the price of all imported goods as it now requires additional units of that currency to secure the same amount of foreign goods.
These two items are where the inflationary effect of QE arises.
One other issue that this article fails to consider is the role of speculators. Any analysis of QE impact that does not take into account the speculator is deficient. This role is closely related to the fact that investors will look to protect their assets from a decline in the currency but it goes a step further. Speculators will look to profit from the weakness in the QE currency by using it to fund a “carry trade”. This involves borrowing that currency, because of the extremely low interest rates, and then leveraging that borrowed money into trades that allow for maximum gains. For example, if one can borrow $1 billion at 0.5% and then invest that into a trade that yields 2.0%, they have just secured a gain of 1.5%.
QE feeds the carry trade frenzy by guaranteeing that the funding currency will not rise in value, which if it did, would offset any potential gain made by the trade. It does this because the money borrowed is then sold or exchanged in order to allow the borrower to make the purchase of other assets which are denominated in a different currency. For example – those speculators who wish to buy Brazilian equities as part of their carry trade must first borrow the newly created dollars, then take those dollar and exchange or SELL them for reals which can then be used to buy the Brazilian equities. This tends to keep additional pressure on the funding currency because the additional supply being created eats through the demand. One has only to look back at the Japanese Yen chart from a few years ago to see how the carry trade can lower the value of a currency.
The carry trade then works to jam higher the price of those assets which are the recipients of leveraged buying which tends to feed into the inflationary impact of points one and two mentioned above.
Perversely enough, the effect of these rising prices on tangible assets, particularly food and energy, can have the effect of actually stalling economic growth since consumers in those nations are forced to deal with the effect of the weakening currency as they must now pay higher prices for the essentials of life and have less income left over for discretionary spending.
Hopefully, this will help you to understand why this course of action is so fraught with danger. I get the distinct impression from reading the article that all of the commotion in the markets is nothing but a mere tempest in a tea pot and all of us are worried for no reason whatsoever. Meanwhile, while we needn’t worry, the Dollar has dropped 12% in value since the summer of this year. The only thing that has kept it from collapsing further is that the Euro is not any better. Any wonder why gold is staying so strong?
AI
