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Nov. 16 featured two events now familiar to traders: Federal Reserve Chairman Ben Bernanke told financial markets to expect low interest rates "for an extended period." And once again the value of the U.S. dollar slipped vs. other major currencies. Both developments were welcomed by traders who are plying the dangerous but profitable "carry trade."
In the dollar carry trade, investors borrow money in U.S. dollars, taking advantage of very low short-term interest rates. Armed with cheap money, they buy up higher-yielding assets. Everything from Hong Kong real estate and commodities to foreign and even U.S. stocks can be driven higher by the carry trade.
Investment flows associated with it can also exacerbate the dollar's weakness. "This kind of carry trade generates remarkable pressure on the dollar," says Michele Gambera, chief economist at Ibbotson Associates, a subsidiary of Morningstar (MORN).
On Nov. 16, the U.S. dollar index—a measure of its strength against a basket of world currencies—lost 0.37% of its value, extending an eight-month slump. A euro is now worth almost $1.50, up sharply from $1.25 in March.
The weakening of the dollar may be good news for U.S. exporters, but it alarms the country's foreign trading partners. Treasury Secretary Timothy Geithner heard concerns about the dollar's strength from Asian finance ministers at last week's Asia-Pacific Economic Cooperation forum. The dollar is also certain to be on President Barack Obama's agenda during his first visit to China this week.
The carry trade is hard to measure, with experts disagreeing about how much money flow is being driven by the strategy. New York University Professor Nouriel Roubini warned earlier this month that low rates are creating a "monster bubble," as cheap dollars push markets to unsustainable heights.
After examining data on trading and fund flows, UBS (UBS) economist Larry Hatheway has concluded that the carry trade is not a major factor. "Price gains largely reflect improved fundamentals, including signs of global economic recovery, the strength of emerging economies, and a recovery of earnings," he wrote on Nov. 12. But Hatheway added: "Identifying—in real time—asset bubbles fueled by leverage is admittedly very difficult."
Other market observers see signs that the carry trade is a key driver of the market's daily movements. "There is a significant carry trade going on," says Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
In some ways, the talk about the carry trade is a good sign for the world economy. The carry trade is a risky strategy and risk-taking is often seen as a "symptom of healthy capital markets," says Bill Larkin, fixed income manager at Cabot Money Management.
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