“As good as gold,” we say to indicate certainty and worth. Gold is safe, according to common wisdom, so rising gold prices are a sign of rising worries. Stock markets, too, are barometers of sentiment, rising or falling with the outlook for the economy.
But lately both shares and the gold price have been on a roll. Gold recently set a new record against the US dollar at around USD 1,050 an ounce. And the Dow just broke the symbolic 10,000 mark, a move that many commentators see as a sign that the financial crisis is over.
Something is wrong with this picture. How can both gold and equities rally at the same time? Is the market schizophrenic, with investors hedging their stock positions by purchasing gold? Or is this yet another skirmish between stock market bulls and gold bears?
Actually, we see a better explanation for this double surge. To connect the dots of causality and correlation, we see one factor common to both rallies: the deeply sagging US dollar. Why is the dollar behind both surges? In short, because carry trades are back.
Carry trading is an investment strategy that calls for borrowing in a low-yielding currency to buy assets in a high-yielding currency. Carry-traders get a quick win from the yield differences, since the higher yield of the purchased assets exceeds the cost of the debt in the low-yielder. When carry trades are in fashion, the exchange rate between the two currencies generates a second gain: High-yielding currencies, being in demand, appreciate against the abundant low-yielders.
The favorite carry trade of the past decade used the Japanese yen for funding and the Australian dollar for investments. Between 2003 and 2007, this trade enjoyed an average annual interest rate differential of 5% and the Aussie appreciated 10% per year versus the yen. Easy money, while it worked. Then, in the course of 2008, the Australian dollar lost 45% against the yen, more than erasing all the gains of the three previous years and putting an end to the strategy of carry-trading, or so it seemed.
But a funny thing happened in 2009: carry trades returned to fashion. The Aussie resumed its starring role as investment currency and the yen reprised its ugly duckling turn as funding currency. But this time the yen has a rival: the once-mighty US dollar. Currently, money-market interest rates paid on the US dollar and the yen are about the same. So the new carry-trade mantra is: borrow cheap greenbacks; buy Aussie assets.
Let’s be very clear on this: it is not the recent dizzying increase in US government debt that explains the dollar’s current weakness, nor is it the astonishing output of the Fed’s printing presses. Carry trades are the cancer eating at the US dollar’s value today.
Now we can connect the dots between the equity and gold rallies: it is precisely the greenback’s weakness that is driving up the price of gold. For a euro or a Swiss franc investor, gold has barely moved this year; for a dollar investor, gold has performed rather well.
We see the makings of an exquisite, truly golden, paradox in the surges of equities and gold: If, for whatever reason, stock markets were to fall by 10%, we might not see gold appreciate in US dollar terms, as would normally be expected; but rather gold’s price would tumble as the unwinding of carry trades would strengthen the greenback.
The financial crisis may be over but one of its notable aftereffects, the high correlation of usually uncorrelated assets like gold and equities, definitively is not. And we expect to see more such paradoxes in the near future.
No comments:
Post a Comment