BULL IN THE WORLD OF TWO CARRY TRADES

I believe that today we are on the threshold of a unique event in the world where there is an opportunity for investors to play via two carry trades alternately and that is something which has been made possible by extremely low short term rates both in the USA and Japan. This is a perfect opportunity for hedge funds and other investors to alternate between two very liquid and alternate currencies whose movement tends to be inverse to each other. In both these countries the short term rates are virtually zero. As such money can be borrowed in one currency invested in risky assets and as that currency becomes oversold shift the strategy to the other currency.
Let’s see how both these currencies have moved since the beginning of the current year. The Japanese yen depreciated from levels of 90 to the dollar at the beginning of the year to a level of 100 by the end of April 2009. In this period borrowings done in Japanese yen and invested in risky assets globally would have yielded high returns as commodities, emerging market bonds and stocks all rallied in this period. If this carry trade was reversed at the end of April then investors would have made money both on the currency as well as on the assets in which investments were made. In this period the US Dollar index moved up in value by nearly 10% from a level of 80 to 90. Now at the end of this period if the currency was swapped and shifted to the US Dollar then from the middle of March to the beginning of June the US Dollar index moved from levels of around 90 to 79, a depreciation of around 12%. In this period borrowing in the US Dollar and investing in emerging market assets and commodities would have made huge money given the pace of the rally from March to May. This trade can be reversed now with the US Dollar looking heavily oversold and the Japanese yen looking heavily overbought.
Now under this scenario where short term overnight rates as well as rates below one year in duration are expected to be kept low by central bankers in the USA and Japan the carry trade can go on continuously and will lead to an explosive rise in mostly emerging market assets. The 3 month dollar LIBOR rate has also come down to its all time low of around 0.65%, which combined with the lowering of credit spreads is likely to make borrowing extremely cheap for strong companies as well as countries that come out with Sovereign bond issuances.
There can be a shift to commodities also; however given the bleak economic growth scenario of the USA, Europe and Japan which constitute 50% of the global GDP a breakaway rally in commodities looks extremely unlikely. Also given the fact there is enough surplus capacity in most commodities like steel, copper, oil, aluminum etc a strong up move in these commodity prices will lead to currently shut down capacities also coming on steam.
However countries in the emerging markets world that are likely to grow strongly i.e. India and China will be the key beneficiaries of this dual carry trade as capital raising will be easy and with surplus liquidity in the system the cost of capital on an overall basis will also remain down. Given the fact that for a country like India even a $ 50 billion inflow is sufficient to take care of our growth needs, the overall inflows are likely to be much higher than this over the next couple of years at least till the time growth remains a priority for central bankers vis a vis inflation.
This phenomenon of a dual carry trade will, over the next three to five years lead to an extremely explosive and dynamic up move in a large number of emerging markets. I will write on my theory on WAVE 3 in one of my subsequent articles.