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The Dollar Carry Trade

The dollar has depreciated roughly 10 percent from its recent peak in March 2009, on a broad trade-weighted basis against the currencies of our key trading partners. Many attribute the dollar’s recent decline to a relatively easy U.S. monetary policy that is fueling a dollar carry trade. The dollar carry trade refers to a set of foreign-exchange transactions that seem to exploit an economic anomaly and entail substantial risk. Perhaps that is why some people fear that the carry trade could unwind quickly and pose adverse consequences for global currency markets.

Although investors can structure dollar-carry-traded transactions in a couple of different ways, at root, they proceed as follows: International investors borrow dollars at very low interest rates and invest the funds in a higher yielding, foreign-currency asset. The investors typically do not cover the transaction by selling the projected foreign-currency payout in the forward market, which would lock in a known return in dollars. Instead, investors bet that the dollar will continue to depreciate, or at least not appreciate to such an extent as to wipe out their gains on the interest differential. Because carry-traders remain exposed to foreign-exchange risk, many observers fear that these investors will run for cover at the first sign that the outlook is not as they anticipated.

Theoretically, such activity should be short-lived. The underlying arbitrage should quickly eliminate the international return differentials by narrowing interest-rate spreads and encouraging the foreign currencies to appreciate in the spot market, and depreciate in the forward market, relative to the dollar. Yet, absent a reversal in the underlying monetary policies, this does not seem to happen. The currencies of countries with low interest rates tend to depreciate, or to not appreciate sufficiently to offset arbitrage opportunities. Persistently low U.S. interest rates and dollar depreciation are consistent with an ongoing carry trade.

Private Liquid Financial Flows versus the Change in the Broad Dollar Index

Measuring the carry trade is difficult. Recent U.S. balance-of-payments data seem compatible with the carry-trade claim but suggest that the effect may be dampening. In recent years, the United States has typically experienced a net inflow of private liquid funds, but between the first and third quarters of 2009, the U.S. experienced a sharp outflow of private liquid funds. (The U.S. also experienced small outflows of private liquid funds in the first two quarters of 2008.) In the third quarter of 2009, however, the net outflow of private liquid funds slowed sharply, according to preliminary data.

Australian Dollar versus US Dollar, 2009
Brazilian Real versus US Dollar, 2009

Dollar exchange rates against key carry-trade target currencies—the Australian dollar and the Brazilian real—seem to tell a similar tale. The dollar depreciated sharply against both of these high-interest rate currencies through the second and third quarters of 2009, but the dollar has shown little movement vis-à-vis either of these currencies since the end of September.

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