The new carry trade?

What is carry trade? Carry trade essentially means borrowing at a place where the borrowing costs are low and investing in another place where the rate of return is high. Carry trade became very popular in the last decade, when Japanese interest rates were close to zero. It came to be known as the Yen carry trade.

Let us look at how investors benefited from the near-zero interest rate in Japan and the high interest rate in other countries (like the US) in the past few years. In 2006, the interest rate in Japan was 0.1%. Let us say an investor borrowed a sum of 115,000 Yen in the Japanese market for one year. At the end of the year the investor will have to return 115,115 Yen (original amount of 115,000 + interest for one year which is 115,000 *0.1%).

In 2006 the interest rate in US was 5.25% and the currency exchange rate was around 1$ = 115 Yen. Suppose the investor converted his Yen to Dollars, he then got $1,000 (for his 115,000 Yen). If he then proceeded to invest his $1,000 in the US market, at the end of the year he would have $1,052.5 (original amount of $1,000 + interest for one year which is $1,000 * 5.25%).

If the currency exchange rate stayed the same, he would then get 121,037.5 Yen ($1,052.5 * 115) when he converts his Dollars to Yen. After repaying the amount due he will be left with 5,922.5 Yen (121,037.5 - 115,115). That is a neat profit considering the fact that all the investor had to do was borrow in one country and invest in another.

(the profit percentage is 5,922.5/115,000 = 5.15%, which is also equal to the difference in the interest rates of US and Japan)

The only risk the investor faces is that of the currency movement. The above calculation assumes that the Yen:Dollar exchange rate stays the same at the end of the year. However, if the Yen appreciates by more than 5.15%, then the investor effectively makes a loss (because he will have to pay more Dollars to get the Yen at the time of repayment).

Due to a host of reasons, the Yen has appreciated considerably in the past year with respect to the Dollar (refer figure). Thus the Yen:Dollar carry trade has come to an abrupt halt. Another reason that has hampered the carry trade is that the interest rates in US is also close to zero now (effectively there is no difference in interest rates in Japan and US).





Hence investors have now started borrowing from countries like Japan and US (where the interest rate is close to zero) to invest in countries where the interest rate is still high (Brazil and India). In Brazil, the interest rate is 11%, so an investor can potentially make twice as much as the Yen:Dollar trade in 2006! The assumption, of course, is that these currencies do not appreciate against the Dollar and the Yen.

Auto Companies: to save or not to save?

After the US government warned General Motors (GM) and Chrysler to shape up or go bankrupt, there has been a huge uproar from many people. The argument goes that if the US government is ready to spend hundreds of billions of dollars to save the banks, then why not spend a few billion dollars to save the auto companies? Although the argument may sound convincing, there are some key reasons as to why the US government should not bail out the auto companies.

The fundamental difference between a bank and any other company is in the service that they provide. A bank’s basic function is to take money from the government (or the Federal Reserve in the US) and loan it out to people and companies. This money forms the basis of all economic activity. Without the banks, corporations will not get money to perform their day-to-day activities. People will not be able to buy things on loan. Companies will not be able to expand their business. The economy will simply collapse.

The auto industry on the other hand, is not as critical to the economy. The industry does employ a lot of people, and also supports a lot of auto-ancillary factories (which in turn employ even more people). However, in case a GM goes bankrupt, there are other car makers (especially efficient companies like Honda and Toyota) which will keep producing cars. Employees from GM can potentially find jobs at other car makers (assuming aggregate demand for cars does not drop sharply).

When the economy was booming; GM, Ford and Chrysler kept on making bigger and more petrol-consuming cars. People were readily getting loans and they kept on buying. As oil prices shot up and the economy went down, the demand for big cars disappeared. The US auto companies suddenly found themselves at a huge disadvantage to companies like Toyota, which had successfully invested in electric and hybrid technology.

The US auto makers are also struggling with huge costs of employees and labor unions, which are a big drag on profits. With falling demand, these companies cannot re-size the workforce as needed.

The simple truth about the US auto makers is that they make more cars than there is demand for, and most of the foreign car makers make better cars at lower cost.

One of the benefits of an economic downturn is that it allows good companies to flourish and destroys uncompetitive companies. As long as uncompetitive companies are allowed to fail, there will be other leaner and better companies taking their place and the economy as a whole will be better off. The best course of action for the US government would be to allow the auto companies to fail. If the government keeps providing these companies with cash, it will promote unhealthy competition (with other countries like UK, Canada, France, Italy, etc. also being forced to subsidize their auto companies).

Housing sees an uptick: should we rejoice?

The boom and bust in the housing market has been the trigger for throwing the world economy in recession. Many pundits believe that for the economy to recover, the housing market should first stabilize. Of late, there are signs that the housing market might be seeing a turnaround. It there a cause for celebration?

In the UK, the Nationwide Building Society reported the first monthly rise in house prices since October 2007. Housing prices which have fallen 17.6% since the start of the crisis, actually rose 0.9% in March!

In the US, the housing prices were down 29% from their peak with home sales going down steadily. However, in February, home sales rose unexpectedly. In Nevada, which with California, Florida, and Arizona was the epicenter of the boom and bust, fourth quarter sales were more than double their level a year earlier.

So what are the causes for this turnaround in the housing sector? One reason is that the house prices have gone down substantially, which makes it a good opportunity for bargain hunters. However, the bigger cause is that interest rates are at an all time low. The government interest rates in the US and UK are as low as 0 - 0.5%! In other parts of the world, interest rates are at or near historic lows. The low rate of interest is making a lot of people jump into the housing market. This includes first time buyers also. However, the only lesson we learn from history is that we do not learn from history.

Just because interest rates are low now, it doesn’t mean they will be low in a few years time. This was the exact same mistake made by house buyers in the US in 2003-05. When interest rates dropped from a high of 6.5% in 2000 to 1% in 2003, many people bought houses using loans. But when interest rates rose again to more than 5% in 2006, many people found out that they could no longer afford to make the monthly payments on their home loans. This lead to defaults and foreclosures, eventually leading to a global crisis.

As the economy recovers in the next couple of years, interest rates will invariably go up from the current historic lows (to counter inflation). People who are buying houses now, must be sure they can afford their house loans even if the cost rises significantly. It is not clear that people are thinking about that.