RGE - Why borrow yen to buy dollars, if you can buy Brazilian real …
リンク: RGE - Why borrow yen to buy dollars, if you can buy Brazilian real ….
Brad Setser | Feb 08, 2007
Or, for that matter, Icelandic krona and Turkish lira …
Borrowing at 1%, maybe less, in a depreciating currency, and buying an appreciating currency that pays 12.4% or so is pretty good business. The Turkish lira pays more 20% , as does the Icelandic krona (14.25% -- Kaupthing Bank has a nice description of the yen funded krona carry trade). But they are a bit more volatile – for a comparison of BRL and YTL volatility last year, see the last two charts of this presentation. And since last July, it is has been really good business.
The 2 and 20 crowd doesn’t even need to use that much leverage on yen funded carry trades in the Brazilian real, Turkish lira or Icelandic krona to maintain their position at the top of the income distribution. That kind of spread works with real money. Or if you finance it with low-yielding Latin currencies rather than yen ...
My colleague Victoria Saddi has noted that Brazil seems to have attracted $10b in portfolio inflows in January alone, judging from the balance of payments data. It attracted $14b in all of 2006 (There was a little sell off in May and June that slowed things down). Brazil’s reserves increased by over $5b in January. That is a $60b annual pace. $60b is huge. It is about twice what the IMF provided back in 2002 - funds that in all probability kept Brazil from a messy default.
Moreover, the pace of reserve growth seems to be accelerating. There are press reports (in Portugese) that Brazil bought $2.5b in three days at the end of last week. That is real money – almost China style money. China has to buy about $1b a business day to keep the RMB down. In the past couple of days, Bloomberg reports that Brazil's central bank bought around $0.5b a day. That isn't quite China's pace, but relative to Brazil's economy, it is a lot. The central bank's data, which lags just a bit, shows that Brazil's reserves are up $2b in the first few days of February.
No wonder State Street’s positioning data shows that an exceptionally large number of investors are betting on the Brazilian real.
Brazil’s government is understandably concerned that this inflow will push the real up too much, undermining Brazil’s competitiveness. Sure, Brazil sells a lot of soy and a lot of iron ore. But Brazil also makes goods that compete with Chinese goods – and, for that matter, Argentine goods. And while high inflation is pushing up the real value of the Argentine peso (despite nominal exchange rate stability), the same cannot really be said of China. The real has been appreciating v. the yuan.
But with market pressure for the real to move up, that means that the central bank is constantly buying dollars to keep the real from rising more. In the process, it removes a lot of volatility from the market. And then I suspect of a bit of reflexivity (to use a Soros term) kicks in. Lower volatility makes carry trades more attractive. Existing carry traders can gear up more without getting into trouble with their risk manager. Others get pulled in. That only adds to the pressure on the real. And that only forces the central bank to intervene even more.
I did some work on Turkey a while back. This is exactly what happened with the Turkish lira in 2005 and early 2006. There was an extended period in 2005 and early 2006 when there was less volatility in the Turkish lira/dollar than in the euro/ dollar. That was the period when Turkish reserves were rising strongly. That, of course, changed in May 2006 ….
Brazil looks to be in a similar boat. So long as the money is flowing in and the central bank is resisting appreciation, there won’t be much volatility. And without much volatility, there is a big incentive to bring money in …
The Brazilian carry trade was popular a year ago (Felix Salmon has the details). it seems to be even more popular now. No wonder there is now talk of doing a reverse currency swaps action to try to stem some of the pressure [Edit: the previous sentence should read "stepping up its use of reverse currency swaps," as Brazil has intervened in the future market for some time -- thanks to OC in the comments]. Brazil’s central bank sold a fair amount of insurance against the depreciation of the real back when that was a risk (in 1998, in 2002), helping to support the real in the spot market. It now seems to be considering doing more or less the opposite …
But capital inflows of 10% of GDP are hard for most emerging economies to handle. And $10b a month works out to a pace well above 10% of GDP for an economy of Brazil’s size. Outflows of 10% of GDP caused the Argentine crisis of 2001 and the Turkish crisis of 2001. Inflows of that side are a bit easier to manage, but only a bit.
The US has a current account deficit of around 7% of GDP, so it needs that kind of inflows (though it would rather not pay Brazilian interest rates to get the money). But for now, Brazil has a small current account surplus – so it doesn’t need the money.
Remember, while investors are borrowing in low-yielding yen to buy high-yielding real, the Brazilians – whether the central bank or the finance ministry – are selling high yielding real debt to buy low-yielding dollars. If every yen that comes into Brazil is bought by the central bank and used to buy dollars, well, the net result is a yen funded purchase of US treasuries. That is the net global flow. The 2 and 20 crowd gets the interest rate on the real and the yen/ real risk. The Brazilian central bank pays the interest rate in real and gets the interest rate on dollars and the dollar/ real risk.
And whenever someone feels forced to take a losing hand, they just might consider changing the rules of the game. I don’t quite see how Brazil can sustain this level of intervention.
The PBoC has positive carry and massive exchange rate risk. The BCB has negative carry and still quite a bit of exchange rate risk.
Comments
I was wondering why Latin American stocks kept on making new highs despite the recent (somewhat) ease of commodity prices.
If they let the real appreciate, wouldn't that make the carry trade (yen/real) even more profitable? Has Brazilian inflation really come down for good?
If they let the real appreciate, wouldn't that make the carry trade (yen/real) even more profitable? Has Brazilian inflation really come down for good?
Written by HZ on 2007-02-09 00:03:15
In this era of globalization the pretension of independent monetary policies seems rather quaint. Will hedge funds call the CBs' bluff on this?
Written by HZ on 2007-02-09 00:05:16
Everybody is now absolutely convinced that JPY won't be going up and that the carry trade is a free lunch. The reasons are well known and I won't repeat them. But it is at the point of maximum conviction (least volatility, etc) that markets "unexpectedly" turn.
One reason why Japan may desire a stronger currency: oil prices are in dollars and Japan imports 99% of what it consumes. If oil prices start heading up again MoF/BoJ may decide that Japan should not pay even more yen for its oil than it has to. In other words, at some point a weak yen will be a greater liability than a benefit.
One reason why Japan may desire a stronger currency: oil prices are in dollars and Japan imports 99% of what it consumes. If oil prices start heading up again MoF/BoJ may decide that Japan should not pay even more yen for its oil than it has to. In other words, at some point a weak yen will be a greater liability than a benefit.
Written by Hellasious on 2007-02-09 01:14:24
Hellasious,
I think interest rate differential will by reduced by US action due to the unfolding of housing bubble. That possibility is almost totally being ignored.
Brad,
You share my concerns that hot money flows distorts investment decısions and cause a loss of competitıvenes vıs a vıs China and India.
But the greedy traders should be concerned that foreign currencies are not already spent on imports from China and OPEC. They may then understand the meaning of 9 percent GDP CA deficit.
Many won't get their money back simply because reserves at central bank are not totally usable and ratio of stock of hot money to the usable reserves is very high.
I am on the record in this blog even Prof Roubini will be proven too optimistic.
I think interest rate differential will by reduced by US action due to the unfolding of housing bubble. That possibility is almost totally being ignored.
Brad,
You share my concerns that hot money flows distorts investment decısions and cause a loss of competitıvenes vıs a vıs China and India.
But the greedy traders should be concerned that foreign currencies are not already spent on imports from China and OPEC. They may then understand the meaning of 9 percent GDP CA deficit.
Many won't get their money back simply because reserves at central bank are not totally usable and ratio of stock of hot money to the usable reserves is very high.
I am on the record in this blog even Prof Roubini will be proven too optimistic.
Written by kaan on 2007-02-09 03:14:44
kaan,
If the Fed cuts rates now it will be admitting that the US economy is weakening and that will have substantial negative effects on credit premiums, i.e. they will shoot up and then the whole game will be up. It is not so much the cost of credit that matters nowadays as the perceived quality of credit, i.e. creditworthiness.
Everyone, their brother, their sister and their unborn progeny have sold trillions in credit insurance, trashing risk and volatility to almost zero in order to collect immediately bookable premiums. Thus, the appearance of a sound and strong economy is of paramount importance to those that have built this rather rickety structure. ("Financial engineering" being the equivalent of "military intelligence", an oxymoron that is just as likely to result in substantial losses in the field.)
In my opinion the Fed won't cut until it is forced to do so by events, eg if a LARGE bank calls the Fed very early one morning and says: "Ahem, we may have to increase loan loss provisions. By a lot".
Regards
If the Fed cuts rates now it will be admitting that the US economy is weakening and that will have substantial negative effects on credit premiums, i.e. they will shoot up and then the whole game will be up. It is not so much the cost of credit that matters nowadays as the perceived quality of credit, i.e. creditworthiness.
Everyone, their brother, their sister and their unborn progeny have sold trillions in credit insurance, trashing risk and volatility to almost zero in order to collect immediately bookable premiums. Thus, the appearance of a sound and strong economy is of paramount importance to those that have built this rather rickety structure. ("Financial engineering" being the equivalent of "military intelligence", an oxymoron that is just as likely to result in substantial losses in the field.)
In my opinion the Fed won't cut until it is forced to do so by events, eg if a LARGE bank calls the Fed very early one morning and says: "Ahem, we may have to increase loan loss provisions. By a lot".
Regards
Written by Hellasious on 2007-02-09 04:18:53
Japanese Data May Boost Yen
China Will Allow `Reasonable' Gains in Yuan to Help Reduce Trade Surplus
China Will Allow `Reasonable' Gains in Yuan to Help Reduce Trade Surplus
Written by Guest on 2007-02-09 06:12:25
dry fly -- tis off topic, but my sense is that the Chinese have limited themselves to the highly rated tranches of private MBS. if someone knows otherwise, do tell.
Written by bsetser on 2007-02-09 07:59:16
http://www.bloomberg.com/apps/news?pid=20601080&sid=aG4l64NjX3Nk - " The currency may rise 4.5 percent to 7.4 against the dollar by the end of this year, Bank of America's Wang said. China is targeting economic growth of 8 percent this year, the central bank said in the report."
Written by Guest on 2007-02-09 11:52:49
Brad, Today (2/9) the Real is falling. Given that it is highly possible that the Central Bank sterilized the inflows, I guess we are starting to observe some capital outflow.
Written by vitoria Saddi on 2007-02-09 11:54:12
Mr Hellacious - so you're saying the Fed won't cut rates if the economy weakens so as not to alarm the credit markets, thus making the economy weaker than it ordinarily would become had they cut rates? and making the credit markets even weaker than they would ordinarily become? Is that what you're saying?
Written by gab on 2007-02-09 14:12:50
gab,
Not at all what I am saying. The Fed will cut when it is forced to by visible weakness in the economy and not before.
To do so right now would be an admission that Goldilocks is indeed dining on cold soup instead of warm broth - something that would not go down very well with markets and may produce more immediate problems than solutions.
It is a weird economy we are having, extremely dependent on capital markets and asset prices instead of production of goods and (non-financial) services. I think the Fed will be very cautious not to be blamed for damaging it by sending wrong signals.
Not at all what I am saying. The Fed will cut when it is forced to by visible weakness in the economy and not before.
To do so right now would be an admission that Goldilocks is indeed dining on cold soup instead of warm broth - something that would not go down very well with markets and may produce more immediate problems than solutions.
It is a weird economy we are having, extremely dependent on capital markets and asset prices instead of production of goods and (non-financial) services. I think the Fed will be very cautious not to be blamed for damaging it by sending wrong signals.
Written by Hellasious on 2007-02-09 14:35:10
Hellaciouls - not to pick nits, but are you advocating the Fed ease before there is weakness in the economy? Why would they do that?
Written by gab on 2007-02-09 17:27:42
Brazil pays 13% in local curreny, the Real. The alternative is US treasury at 5%, a delta of 8%. Brazil floated its currency in 1999, when the Real was pegged 1 to 1 vis-a-vis the US dollar. The Real hit almost 4 to US dollar a couple of years ago and now sits at 2, in other words extremelly volatile currency. A slight run against the Real and there goes your 8%!
Written by Guest on 2007-02-09 17:55:11
Brad, is there any international risk in a collapsing yen? Say to 140 or so?
I'm just concerned that Japanese household consumption could be accelerating to the downside, and I wouldn't be at all surpised to see investment dropping as well.
I'm just concerned that Japanese household consumption could be accelerating to the downside, and I wouldn't be at all surpised to see investment dropping as well.
Written by stuart mills on 2007-02-09 17:58:12
vitorria -- if I had to guess why the real is falling, i would say that some people took off yen funded carry trades heading into the g-7 meeting, just in case.
mr. mills -- sure, the yen could fall to 140. I have learned that a lot of things are possible. I wouldn't have thought the US could have run current account deficit as large as it has three years ago, for example.
But i think a 140 $/ yen is unlikely. I would expect the Japanese would intervene well before then, and others might join ... and i suspect the intervention would set a floor under the yen. the yen is already very weak in real terms, so another 20% fall would really push it out of any historical range.
mr. mills -- sure, the yen could fall to 140. I have learned that a lot of things are possible. I wouldn't have thought the US could have run current account deficit as large as it has three years ago, for example.
But i think a 140 $/ yen is unlikely. I would expect the Japanese would intervene well before then, and others might join ... and i suspect the intervention would set a floor under the yen. the yen is already very weak in real terms, so another 20% fall would really push it out of any historical range.
Written by bsetser on 2007-02-09 23:30:20
gab,
Nits, nits everywhere and not a one to pick! (smile)
Let me immediately say that I am not a professional Fed watcher, so feel free to throw as many of the following nits at me as you may see fit.
I believe the Fed (and many many others) understands this economy pretty well: it is dependent on asset appreciation (stocks, bonds, real estate...) and stable market behavior. All markets are now interconnected via derivatives, particularly credit default swaps (CDS). There is (was?) a self-sustaining positive feedback loop in operation right now: credit markets connect to equity markets and equity markets connect to credit markets. The plumbers over at (bank that shall remain nameless but we all know who they are) dreamt up credit default swaps as the loop mechanism and boy has it worked! Risk and volatility premiums have collapsed and that has meant enormous income for those that sold them. But in the end it IS all naked put writing...risky stuff.
Bottom line: the Fed cannot afford to be the one blamed for the system's collapse if/when it occurs. If it turns around right now and cuts interest rates it would be like yelling the emperor has no clothes - it may be fact but... No, I think it will keep rates steady until someone ELSE cries "no clothes" and then it will quickly act to do what it always does.
In plain English: steady rates until the economy shows clear proof of weakness or there is a real mess in banking/markets.
Regards
Nits, nits everywhere and not a one to pick! (smile)
Let me immediately say that I am not a professional Fed watcher, so feel free to throw as many of the following nits at me as you may see fit.
I believe the Fed (and many many others) understands this economy pretty well: it is dependent on asset appreciation (stocks, bonds, real estate...) and stable market behavior. All markets are now interconnected via derivatives, particularly credit default swaps (CDS). There is (was?) a self-sustaining positive feedback loop in operation right now: credit markets connect to equity markets and equity markets connect to credit markets. The plumbers over at (bank that shall remain nameless but we all know who they are) dreamt up credit default swaps as the loop mechanism and boy has it worked! Risk and volatility premiums have collapsed and that has meant enormous income for those that sold them. But in the end it IS all naked put writing...risky stuff.
Bottom line: the Fed cannot afford to be the one blamed for the system's collapse if/when it occurs. If it turns around right now and cuts interest rates it would be like yelling the emperor has no clothes - it may be fact but... No, I think it will keep rates steady until someone ELSE cries "no clothes" and then it will quickly act to do what it always does.
In plain English: steady rates until the economy shows clear proof of weakness or there is a real mess in banking/markets.
Regards
Written by Hellasious on 2007-02-10 01:23:50
"During 2006, while India and China were all the rage Brazil's exchange traded fund (ETF), iShares MSCI Brazil Index (EWZ), was up 45%. Carl Delfeld's main concern is if Brazil's economic recovery is sustainable or just another stage in the economic cycle. He says most of Brazil's stock market growth is not due to economic growth but rather a result of the commodity boom. Inflation is low and an annual average growth rate of 2.6% is a crawl. But the trade surplus is at $46 billion after paying off it's debt..." http://www.etftrends.com/brazil/index.html
Written by Guest on 2007-02-10 06:50:32
"There are already signs that more unstable types of speculative short-JPY positions have been established recently. We believe that the MoF should consider intervening to support the JPY if a vicious cycle develops. Thus, the motivation to intervene to stabilize JPY could come from Japan, not Europe or the US..." http://www.morganstanley.com/views/gef/archive/2007/20070209-Fri.html#anchor4367
Written by Guest on 2007-02-10 08:41:04
Brad: Brazil has already been selling reverse currency swaps for sometime... Ask Victoria.
Written by oc on 2007-02-10 11:38:44
Odd that Jen is more concerned with speculative sorts of carry trades. In a big diversified economy the sht should not hit the fan till hedging supplants speculation as a source of pressure on the currency. And Yen support is easier to imagine coming not from intervention but from news. Take Europe's hairy leveraged loans , which could conceivably help out the yen without a lot of jawboning. In the case of 2nd & 3rd liens, where the arranger's more important than the structure, the counterparties' payout simulations have more scope to diverge and the structured-finance pattern of fewer bigger re-grades could interact spectacularly with fat-tailed currency risk. Correlation regimes could change, especially now, when Europe's credit cycle seems strangely amplified, even compared to the US' hobo-palace capital market.
Written by psh on 2007-02-10 12:47:00
OC, thanks. Since I won't talk to Vitoria before monday, maybe you could help me understand this statement in the Bloomberg article I linked to -- it suggests the Brazilians are considering some change in their use of reverse currency swaps.
"Investors expect the central bank to step up dollar purchases to slow the real's appreciation, ``or even do something a bit more radical like a reverse currency swap auction,'' according to Gerson de Nobrega, who helps manage 3.8 billion reais ($1.8 billion) in assets as head of the money market trading desk at Banco Alfa Investimento SA in Sao Paulo. Reverse currency swaps allow investors to hedge against a weaker dollar by locking in a fixed exchange rate to sell the U.S. currency in the future. ``With the real gaining like this, and at the speed we've seen recently, we should expect some kind of move by the bank,'' Nobrega said. The central bank has been buying dollars every day on the spot currency market since July to cool the real's rally."
Would the innovation be holding an auction rather than just entering into the reverse currency swaps?
"Investors expect the central bank to step up dollar purchases to slow the real's appreciation, ``or even do something a bit more radical like a reverse currency swap auction,'' according to Gerson de Nobrega, who helps manage 3.8 billion reais ($1.8 billion) in assets as head of the money market trading desk at Banco Alfa Investimento SA in Sao Paulo. Reverse currency swaps allow investors to hedge against a weaker dollar by locking in a fixed exchange rate to sell the U.S. currency in the future. ``With the real gaining like this, and at the speed we've seen recently, we should expect some kind of move by the bank,'' Nobrega said. The central bank has been buying dollars every day on the spot currency market since July to cool the real's rally."
Would the innovation be holding an auction rather than just entering into the reverse currency swaps?
Written by bsetser on 2007-02-10 12:53:56
oc -- right you are; brazil clearly has used reverse currency swaps extensively in the past. they must be contemplating some change in the way that they use the swaps.
http://www.morganstanley.com/views/gef/archive/2006/20060118-Wed.html
http://www.morganstanley.com/views/gef/archive/2006/20060118-Wed.html
Written by bsetser on 2007-02-10 13:00:45
Brad - A bit off topic but thinking of 'risk'... is there any recent official response out of PBoC regarding the problems with US MBS... considering the HSBC flap & the issues with sub-prime? Do we know if they've bought this kind of junk too? Are they now shying away from MBS as a result?
Just curious. Its starting to get kinda interesting... in a not very pleasant sort of a way.