Hedge Funds’ ATM Moves From Tokyo to Washington


Sept. 18 (Bloomberg) — China is getting all worked up about the wrong thing when it comes to the U.S.

Forget these nascent trade wars over tires, cars and chickens. China’s real problem is how quickly the dollars they hold in great quantity are getting all the respect of pesos these days. Sound like hyperbole? Not when you consider what may be the hottest investment of 2010: the dollar-carry trade.

Move over Japan. Investors spent a decade borrowing in zero-interest-rate yen and putting the funds in higher-yielding assets overseas. It’s the U.S.’s turn to flood the world with cheap funding and the risks of this going wrong are huge.

The carry trade has never been a proud part of Japan’s post-bubble years. Officials in Tokyo rarely talk about the yen’s role in funding risky or highly leveraged bets on markets from Zimbabwe to New Zealand. Japan never set out to become a giant automated teller machine for speculators. It was a side effect of policies aimed at ending deflation.

The perils of the carry trade were seen in October 1998. Russia’s debt default and the implosion of Long-Term Capital Management LP devastated global markets. It was a decidedly panicky and messy period culminating in the yen, which had been weakening for years, surging 20 percent in less than two months.

Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely.

Cheapest Currency

“The dollar is the cheapest funding currency bar none and only challenged by the U.K. in terms of the risks from money printing and escalating deficits,” says Simon Grose-Hodge, a strategist at LGT Group in Singapore.

Three-month London interbank offered rates, or Libor, for dollar loans are at a record low and fell below those for the yen on Aug. 24 for the first time in 16 years.

Think about the turbulence that would be unleashed by the dollar suddenly shooting 5 percent or 10 percent higher with untold numbers of traders around the globe on the losing side of that trade. It could make the “Lehman shock” look manageable.

The U.S. once was a beneficiary of carry trades. The gap between U.S. and Japanese bond yields offered a payoff. You could borrow for almost nothing and buy U.S. debt, receiving a twofold benefit: the 3-plus percentage-point yield difference and the dollar’s strengthening versus the yen. The latter dynamic boosts profits when they are converted back to yen.

How Big?

Yen borrowers bought everything from Shanghai properties to Google Inc. shares, bars of gold, Zambian treasury bills and derivatives contracts. The odd thing, however, was the lack of credible data. When I asked Japanese officials in recent years for estimates of how big the yen-carry trade had become, I got blank stares.

That’s what makes such a trade worrisome and easy to dismiss as a threat to markets. No one knows how big it is — how many companies, hedge funds or mutual funds borrowed or how much. So when a currency turns suddenly, the magnitude of the unwinding is often a surprise.

The dollar is under pressure for valid reasons. Deficits are widening faster than U.S. officials can measure, and debt- issuance plans are increasing. The U.S. is in recession and the Federal Reserve is still shoveling liquidity into markets.

Dollar Concerns

Add to that China’s growing concerns about its dollar holdings — more than $800 billion of U.S. Treasuries — which may lead to fewer Chinese purchases. That also goes for Japan, which has $725 billion of U.S. debt.

Really, betting against the dollar would seem to be as safe as assuming Japanese 10-year bond yields will stay at less than 2 percent. And if Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke aren’t careful, the dollar will become the main trade dispute with China.

U.S. President Barack Obama’s 35 percent tariff on tires from China spurred a Chinese investigation into prices of U.S. poultry and car products. That’s small beer compared with the magnitude of the task facing Geithner and Bernanke should China pull the plug on Treasuries.

China would be hard-pressed to do that, of course. Its dollar holdings are about keeping the yuan low and helping exporters. Still, any hint China would be buying fewer Treasuries could send the dollar lower.

What if, for example, a U.S. recovery comes faster than expected, sparking a massive reversal of the carry trade? Its implications would be felt far more widely than shifts in yen bets. Increased dollar volatility could even bring down a few hedge funds and the odd investment bank.

The dollar-carry trade says nothing good about confidence in the U.S. economy. It’s also a reminder that the side effects of this crisis may be setting us up for a bigger one.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: William Pesek in Tokyo at [email protected]

Last Updated: September 17, 2009 15:00 EDT

Source: Bloomberg

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