Carry Trade: No More "Excess Liquidity"?

By Vadim Pokhlebkin

I must admit that when it comes to my investments, I'm still having trouble thinking "globally."

In my defense, it's hard to think that way when you live in a country that feels like a world into itself. Besides, it almost seems silly to chase overseas markets when you've got the Dow, the world's benchmark stock index; when I'm lured to invest into a 401K plan at work; when my bank tempts me with CD offers every time I use the ATM; when I can trade stocks, forex and whatnot while flipping burgers on my back yard grill, for pete's sake.
With so many easy choices to put my money to work right here, why risk sending it off some place I've only seen on the Discovery Channel?

Well, maybe because that's how you catch the best opportunities these days. After all, last year the best performing markets were not in the U.S. – they were in India, Russia and China, whose stock markets rallied 47%, 67% and 130% respectively. More and more, it pays to look across the international borders. And many shrewd investors have been.

Take the so-called carry trade, for example. Still relatively unknown to mainstream investors, this little wonder has been rumored to be responsible for all the "excess liquidity" (read: rallies) in the global markets lately. There is no easy way for an average investor to take advantage of carry trade, but because of its allegedly enormous influence, it's well worth talking about.

A carry trade is another way for market players to take advantage of global inefficiencies. In a nutshell, you borrow money from countries that have a low interest rate and invest the funds in countries where the rate is higher. Lately, a popular choice has been to borrow in Japan, where the interest rate until yesterday (Feb. 21) has been a measly 0.25% and invest in New Zealand securities, which currently yield over 7%. Beautiful.

Carry trades became popular circa 1999. No one really knows exactly their total volume since then, but estimates say that in 2006 alone, it came close to $58 billion. Talk about "excess liquidity"! "The carry trade," says The International Herald Tribune, "has become a major source of low-cost capital for the world, with money flowing into everything from Wall Street stocks to real estate in South Korea, India and even Eastern Europe."

But rumors are, it may all be over soon.
On Wednesday, the Bank of Japan raised interest rates to 0.5%. A quarter-point isn't much, yet still there is fear that this will put a damper on carry trade, "excess liquidity" and all the global market rallies that it has allegedly created.
You'll probably be surprised to hear our opinion on the matter, but from an Elliott wave perspective, carry trades have done a lot less to boost global markets than they are given credit for. The only reason markets have rallied since 2003 is investor confidence. Carry trade is just a tool investors have used to put their money to work. It's a tool, not the cause. Here's how we put it in the January issue of The Elliott Wave Financial Forecast:

"...Today's bullish buzz concentrates on the process by which liquidity is created, whether via the yen carry trade, Federal Reserve repos or the securitization of bizarre credit instruments. This focus completely misses the point, in our opinion. Regardless of the process, the psychological foundation of liquidity is confidence. We cannot stress this point strongly enough. When investors are optimistic, confidence remains high and liquidity expands."

What's the reason of this investor confidence, you ask? The short answer is, there is no reason. "People are bullish because they are bullish." Even if carry trade stops working eventually, investors will find other ways to "create liquidity" – as long as they in the same bullish mindset they have been.
But "when this optimism goes away, the spigot will run dry, no matter what the 'reasons' that people may place on it."
And if you find this idea intriguing, stick around – we have plenty of others.