End of the Currency Carry Trade

Ft.com's Steve Johnson reports that BNP Paribas' FX Strategy Indicator is turning negative on the carry trades.

Carry trades are simply borrowing money in a country/currency with low rates and lending it in a country/currency with high rates, capturing the difference.

The spread between the two rates is the source of profit, when it shrinks so does the payoff.

The U.S. dollar has been the beneficiary of the carry trade because of the higher yields available on U.S. debt securities. With the decline of the carry trade there will be less demand for the dollar.

These kinds of gifts to the market are often the result of central bankers attempts to evade reality by "liquifying" their economies and keeping rates artificially low in order to induce more economic activity and allow their politicians to stay in office for just a little while longer.

For example, rates in Japan were held down to zero while they attempted for years to end the deflationary spiral that was the consequence of their own prior action.

So while they created credit and pumped out new money 24/7, smart banks and hedge funds were borrowing that money for nothing and lending it to the U.S. treasury--and pushing up the dollar in the process. Note that the Japanese central bank was pumping it out hoping it would be spent domestically to the benefit of the Japanese economy and instead that money ends up financing the U.S. budget deficit thank you very much. No wonder their reflation attempts were not having the desired effects.

And that doesn't even count the direct purchase of U.S. dollars or government debt by their central bank held as foreign currency reserves.

The end of the carry trade? Don't worry about it, if history is any guide there will be ten more central bank freebies out there to take it's place.