Wednesday, December 17, 2008

Has the carry trade been unwound? (2) -- yes

Sure looks like it has been unwound. Indeed, evidence is starting to accumulate that the carry trade is being put back on. This chart illustrates how tightly gold and the dollar have traded this year. Strength in gold mirrors weakness in the dollar, and weakness in gold tracks strength in the dollar. Gold is a good proxy for all things physical, so when it rises in value it generally reflects a weaker dollar and more expensive things. Gold has some unique qualities, one being that it is the most sensitive of physical things to respond to underlying changes in the fundamentals that determine the dollar's value.

The recent collapse in the dollar and resurgence in gold is thus good evidence that the Fed has succeeded in over-supplying dollars to the market via its new zero interest rate policy and its aggressive purchases of all sorts of assets. With money now virtually free, the market is willing to accept the Fed's offer of cheap dollars: the carry trade is being reborn. Borrow now, secure in the knowledge that borrowing costs will remain exceptionally low for quite "some time," and buy gold, buy homes, buy commodities, etc.

Thus begins a new reflationary cycle in the U.S. economy. Sadly, we've had one too many already, with the last one beginning in 2003 and ending preciptiously last July.

8 comments:

Chris said...

Scott - thank you for your insight as I am new to your blog it would be great to know what newpapers/journals/magazine/etc. that you read on a regular basis. Also some of your top books.
Have a great holiday.

Brian said...

Scott - Could you share your thoughts on whether this winter would be good timing for a refinance, or if the spring should set us up for even lower rates? I know the 10 year T-Bill is the basis to watch, and it seems that rates should be lower than they are right now...
Thanks!

Bernard said...

I thought the goal of the Fed was price stability. As you have pointed out, we have seen a continual uptick in the volatility of prices with the Core CPI heading north. It seems like over the pat decade the Fed has been more concerned with economic growth and the avoidance of recessions rather than price stability, any thoughts?

dave said...

The real role of the Fed is dollar stability, as the fed can't provide price stability.Prices in the economy change all the time, and provide important signals to actors in the economy regarding supply and demand.

Scott Grannis said...

Brian: I think mortgage rates have been slow to follow the plunge in 10-year yields. Be patient, they should continue to fall. This will be a fabulous opportunity to buy homes and/or refinance.

Scott Grannis said...

Bernard: The Fed has a fundamental problem since it has a dual mandate: to foster price stability and full employment. These objectives are not always compatible. Theoretically, if they actually delivered price stability then the economy should take care of itself. But too often they (like now) abandon price stability in favor of rescuing the economy. It would help if Congress clarified their role, giving them a single mandate.

Scott Grannis said...

Dave: A stable dollar should lead to price stability (on average), even though you would still expect to see lots of prices moving up and down.

Scott Grannis said...

Chris: (finally getting around to answering, sorry). I read so many things, including the blogs listed on my site. The Wall Street Journal is the one thing I can't miss every day. I used to read a lot of newspapers and magazines but over the years have dropped most of them. I focus instead on the columnists that I respect like George Will and Bob Novak, and find a lot of things on different web sites.

The late Jude Wanniski had a big influence on me, and you can read most of what he wrote at his website www.polyconomics.com. I'd highly recommend his book "The Way the World Works."