How They Carry On!

When you listen to financial guru’s discuss the imminent demise of quantitative easing, you might conclude that higher interest rates are lurking just around the corner.  Headlines argue about “lift off,”  the date when our Federal Reserve begins raising interest rates.  One thing all seem to agree on is that it is not a matter of if, just when.  Atlas won’t argue about the ultimate inevitability that rates must go up at some time; after all, right now they are sitting close to zero.  Unlike most pundits however, we don’t see it happening in a meaningful way anytime soon.

High finance, meaning the guys who push big bucks around the world orchestrating foreign exchange and global trade (including the biggest banks with an international reach), manage risk via a process called the carry trade.  Not insignificantly, they also use this process to speculate with their own investment accounts in arenas they tend to dominate, if not control outright.  Here’s how it works: borrow money from a country that charges low interest rates and buy bonds from a country that pays higher rates.  For instance, you could borrow money from German banks at very low rates and invest in U.S. bonds with a ten-year maturity.  Currently such a strategy has the potential to yield a decent return with seemingly little risk if you have a couple billion dollars laying around.

This carry trade has consequences.  Most obvious, the demand for the currency needed to buy those higher-yielding bonds tends to force the price of that currency higher.  This demand for the higher-paying bonds tends to raise their price, thus lowering the yield for the next buyer.  Such mechanisms generally tend to be short-lived, arbitraged away in normal daily trading.  There are times, however, when the effects can be longer lasting and pernicious.

Many nations, especially the developed ones, have huge economies.  As ours here in America continues to show encouraging signs that we are returning to a more robust level of growth, funds from around the world seek to take advantage of our (relatively) higher rates.  They buy  dollars which drives the price of our currency up.  This allows American’s to buy foreign goods more cheaply at the expense of those produced domestically.  Producers here begin to complain about unfair trade practices.  Congress begins debating how to punish our partners of dumping.  Trade sanctions often follow. Additionally, nations that borrowed money in dollars find they can’t service the debt as it becomes ever more costly to convert their depreciating currency into U.S. funds.  Talk surfaces about sovereign default in countries that suddenly seem candidates for bankruptcy

This isn’t news to our own Federal Reserve.  We believe they will do their best to avoid seeing most of these issues manifest in the near term.  The quickest way to ensure this would be to lower rates here.  That might not happen, but it sure seems unlikely that they will raise them anytime soon.  Rather, they may decide to wait until our other major trading partners like Japan and the Eurozone show signs of sustainable recovery.  And that, in our opinion, still lies a long way off.     (by J R)