The Importance of the FX Carry Trade

Trade gap dollars come back to the US economy via several routes:

Foreign central banks can acquire US assets, including treasuries, agency debt, corporate debt and equities. They can get these dollars when they intervene in the foreign currency markets with dollar purchases or when foreign exporters convert dollars to their local currencies. Either way, the foreign central banks bolster their balance sheets and keep the dollar propped up by creating demand for dollars.

Foreign corporations can also buy US assets, doing their own part in maintaining the strong dollar and keeping up demand for their products. When foreign companies build factories on American soil they also improve their competitive position relative to US companies.

Private foreign investors also buy US assets. While foreign investment in US stock markets has declined since the dot-com bubble, the acquisition of entire companies may be picking up.

The three routes mentioned above all result in wealth transfer from the US to the rest of the world, but they seem to be declining in popularity as the US becomes a poor credit risk. Over the past couple years the trade gap has grown with the dollar remaining strong due to a dangerous and unsustainable function of the financial markets.

When the Federal Reserve started raising short term rates substantially it created a new avenue for trade gap dollars to flow back into the country via the FX carry trade. Hedge funds and other currency speculators could borrow foreign currencies at low rates, purchase dollars on the open market and then invest those dollars at higher US rates.

This form of the carry trade works as long as the dollar doesn't decline rapidly against the foreign currency where debt is incurred. The more people playing this trade the better it works because surplus dollars are soaked up out of the forex markets and put into the US investment pool. The dollar stays strong and the value of US assets get a boost as well. Of course the unwinding of these trades could be rapid and devastating if things get out of hand.

An unfortunate side effect is that the tremendous amount of money being borrowed into existence is inflation and foreign central banks around the world are boosting rates to combat it. The fed has to continue raising rates relative to other central banks or the forex carry trade could be forcibly unwound. Meanwhile short term rate differential must be maintained via rising fed funds rates in order to soak up dollars via the FX carry trade. At the same time, bond yields must be kept down so that current carry traders aren't unwound by declining bond values. Finally, the dollar must also stay strong to keep carry traders above water.

With foreign official purchases reversing to sales, the treasury may now be meeting its demand for funds thanks to hedge funds employing the FX carry trade. Fund managers are collecting their management fees based on their paper profits for now, but there is no way they'll be able to get out cleanly when the system eventually breaks down. I suspect (Goldman Sachs CEO turned Treasury Sectratary) Paulson is scrambling to buy time for insiders to get out of unstable positions and secure their 2006 Christmas bonus checks before it all comes crashing down.