Posted on 08 January, 2010 | No Comments
The fed funds rate has been at an historic low of 0.14 percent for sometime now, meaning it costs almost nothing for banks to borrow money, and then lend it out at a high premium. In 2009, borrowing US dollars cheaply to fund purchases of higher-yielding assets was a no-brainer, especially with the comfort of the Federal Reserve’s repeated assurances that U.S. interest rates would stay low “for an extended period.”
The “carry trade,” as this strategy is known, in which deep-pocketed investors borrow low-interest US currency to buy higher-yielding assets like stocks and commodities, helped carry the stock market through 2009. After a schizophrenic 2009, which began with the world in the depths of the worst crisis in 70 years and ended with the S&P 500 headed for its best year since 2003, few know what to expect in 2010. The so-called “carry trade,” may not be a sure a bet in 2010.
Institutional investors, who borrow large sums of cash, drive the carry trade. The worry is that institutions will start sell to cover their borrowed positions. “As large institutions unwind the carry trade, you’re going to have excess volatility that’s going to have to bleed out, and it’s going to bleed out over multiple asset classes,” said Todd Hanson, head of forex trading at Team Trading. “I see a lot of retail investors getting stomped on and a lot of options players making out like bandits.”
Some strategists are afraid that the rally could be running out of gas and ready to bite those late to the party. “I don’t think you ever have a gradual unwinding,” said Cliff Draughn, president and chief investment officer at Excelsia Investment Advisors in Savannah, Ga. “Selloffs are much quicker than buy-ins. The end for greed is underweighted by the factor of fear. Fear invades your consciousness much quicker than greed does.”
While the Fed reiterated its intention to hold rates low well into the new year, recent employment and consumer spending data have suggested the economic recovery is starting to gain traction. The U.S. central bank also said it intends to shutter most of its emergency lending programs by February, another sign of confidence in the economy and a potential boon for the buck. So there are concerns that the Federal Reserve at some point this year will have to start raising interest rates to control growth and support the dollar.
Bottom Line: Even though investors are likely to continue using cheap dollars to buy higher-risk assets in the early part of 2010…be careful of rising interest rates and the end of the ‘Carry’ trade down the road.