The New Carry Trade
John Mauldin's Outside the Box

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This week we will turn once again to a group headquartered in Hong Kong with offices in Stockholm and New York called GaveKal Research Limited. We pull together three one page commentaries from last week that focused on the carry trade.

They make the point is that over the last ten years the carry trade has moved from the Yen to the US Dollar and is now moving to the Euro. This is a short concise piece that gets right to the point and brings a lot of ideas. Most economists are still forecasting a weak dollar, but GaveKal presents a scenario that could lead short-term to a strong dollar and even weaker Euro. This is an outside of consensus view, which is why this was picked for Outside the Box.

- John Maudlin

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Playing With Fire?

As we never get bored of pointing out, structural bear markets and deflationary busts only happen when policy makers commit one, or several, of what we call the "five cardinal sins". The five sins are: 1. Protectionism, 2. Tax Increases, 3. Increases in Regulation, 4. Monetary Policy Mistake, 5. A War. The common thread behind these five policy mistakes is that, when committed, they reduce the returns on invested capital and consequently, asset prices are pushed lower. And this puts the financial sector in trouble etc...

Now why do we return yet again to this long-held, and long-exposed, belief? For the simple reason that we are very confused by the recent protectionist rhetoric coming out of Washington DC. Indeed, the efforts to push China to revalue appear to us to be both clumsy, and dangerous.

It is dangerous because it is playing into the hands of the protectionist lobbies all over the world. It is clumsy for a revaluation, even a large one, would have no impact on the US current account deficit. Why? Because given the state of excess capacity in China in almost all industries, the costs of a RMB revaluation would simply be passed on to the margin of Chinese companies (already inexistent) and not unto the US consumer. In other words, if China revalued tomorrow by 20%, Wal-Mart would tell its widget manufacturer in Guangzhou: "last week you were producing this for US$1. This week, you will continue to do the same... Or I move my production to some guy in Shanghai/Saigon/Jakarta etc...)." So can China really afford a revaluation?

We will turn that question around and ask you to put yourself in the shoes of a Chinese policy maker. This is the situation you are facing today: a) you have the world's worst performing stock market which is hitting 8 year lows), b) you have the world's best performing bond market (Chinese 10 years have moved from 5.25% to 3.7% in the past ten weeks), c) you have industrial production rolling over (weak oil consumption, weak iron ore imports, weak Baltic, weak steel prices, weaker industrial production numbers...), d) you have real estate activity rolling over (our friend Simon Hunt reports that an "indicator of the real slowdown in real estate is that a major supplier of chiller tubes (chiller units are the central air conditioning units for all apartment and office blocks, hotels etc.) reports a 25% fall in 2nd quarter orders with no visibility for the 2nd half of the year. After talking with his customers, he was told that other suppliers are faring even worse...", e) inflation has fallen from +5.3% to 1.8% in ten months, f) M1 growth has fallen from +20% to +10% in the past year... In other words, nothing in China's economic data, or market performance points to the need for a RMB revaluation.

And yet, the Bush administration keeps banging on about it? Why?

Explanation #1: Could it be part of a greater geopolitical game? In other words, what President Bush is really worried about in Asia is North Korea. He does not really care about the RMB; he just pretends to care. This allows him, in negotiations with the Chinese, to say: "I will fold on the RMB, if you give North Korea up; in that way, you guys can give up your embarrassing ally without losing face".

Explanation #2: The Bush Administration, given all of the above, is getting worried about the potential for RMB devaluation and is kicking up a fuss to make sure that this does not happen.

Explanation #3: the Bush Administration is clueless and playing with fire.

Meeting clients around the US in the past ten days, it felt that 100% of our clients subscribed to the third explanation. Time and again, we were told that "no way are these guys smart enough for Options #1 or #2". And, while we have never been accused of throwing stones at the current US President, we fear that our clients might be unto something. The current administration is playing with fire.

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Asia and the Unwinding of the US$ Carry Trade

As our more faithful readers know, we have spent a lot of time in the past 18 months looking at the growth in the US current account deficit, the growth in Asian central bank reserves etc... And all of our work has constantly drawn up the same conclusion: in the past couple of years, Asian central bank reserves have grown much more rapidly than domestic current account surpluses and foreign direct investments; in recent years, Asian countries have managed to save more than they have earned. Last year, in China, the difference was some US$80bn... or nearly 6% of Chinese GDP.

This, of course, begs the question of where this money came from? The answer, we believe, is simple enough: the excess US$ that have showed up in central bank reserves represent borrowed US$; not earned US$. A quick example: in 2003, most of the simpletons who sit in the GaveKal HK office became convinced that the RMB was set to revalue. To cash in on this one time bonanza, a "get-rich quick" scheme was put together: the first step involved purchasing real estate on the Mainland (one of the few RMB denominated assets easy for foreigners to purchase). The second step involved securing mortgages on the property denominated in US$. The end result was clear: a US$ liability attached to a RMB asset. Elementary my dear Watson...

So elementary in fact that, as the rumors of a RMB revaluation accelerated, everyone and their dog got in on the trade. And before we knew it, we faced a) a massive construction boom in every Chinese city (hereby depressing rental yields) and b) a growth in the PBoC's US$ reserves that had nothing to do with either trade or direct investment flows and everything to do with speculative leverage.

With an economic slowdown unfolding in China, a revaluation becoming increasingly unlikely, a rising US$, rising US interest rates, and Chinese companies lining up to get money out of China, a number of participants (from Taiwan, HK, Singapore, Indonesia....) in the above real-estate/RMB trade might start to re-think whether the above trade is as one-sided as it appeared two years ago. If they conclude that it isn't, some will sell, turn their RMB to the PBoC and ask for the US$ back to re-pay the bank. Now obviously, the PBoC is swimming in a sea of US$. So it will have no problems meeting that demands for reimbursement. But as it reimburses, the Chinese money supply will shrink. Unless, of course, the PBoC allows the RMB to fall, which, given current political circumstances is unlikely.

The extent by which the Chinese money supply will shrink could well end up being dictated by the extent to which the PBoC has engaged in "reserve diversification". Indeed, if the PBoC has used the "borrowed US$" to buy Euros, AU$ or Yen, then as speculators come forth and ask for their US$ back, the PBoC will be in a bind. It will need to cash in the speculators demand, and sell Euros or Yen at the same time to make sure it maintains enough US$ to defend the RMB peg.

Needless to say, the operation of the PBoC are very opaque, and we have no idea the extent to which they have engaged in reserve diversification. But we know more or less what the Hong Kong Monetary Authority has been up to; our friend David Scott writes: "the HKMA might have cut its US$ holdings to around 70% of total reserves. This is very bullish for the US$. The HKMA has a 100% Dollar target for its currency. So now it faces a) rising US interest rates relative to other currencies - so relative yields on its investment portfolio will be suffering. b) Rising HK rates relative to Euro rates ie the cost of its liabilities will be rising relative to the yield on its assets. c) a partial currency mismatch. We believe the unwinding of the US$ carry trade will affect Asia disproportionately; especially countries with pegged currencies (HK, Malaysia, China) which will be unable to cope with the unwinding of the US carry-trade by allowing their currencies to weaken (something Japan and Thailand are already doing).

Out With the Old, in with the New Carry Trade

Every now and then, central banks fall asleep on the job and allow their currencies to achieve very overvalued levels. In turn, this slows down the underlying economy, a fact which then forces the central bank into cutting rates aggressively to counter-balance the tightening done by the FX markets. When such a turn of event occurs, financial market participants jump on it with both feet; all of a sudden, financiers are given an opportunity to borrow in a currency which a) goes down and b) whose borrowing costs keep falling. What we are describing above is not theoretical. In fact, it has happened twice in the past decade. And it is about to happen again. A fact with important investment consequences.

Between 1995 and 1998, a number of investors participated in the great "Yen carry trade". For three years, it was fantastic: whatever one bought with one's borrowed Yens, one made money. Until one did not; and then the unwinding of the Yen carry trade was both violent, and painful for those involved in it (Tiger, Sumitomo...).

From 2001 to 2004, we experienced the great US$ carry trade. As we tried to show in a number of reports in the past couple of years a large number of people borrowed US$ on the premise that a) the US$ could only go down and b) borrowing US$ was nearly free (1% interest rates) and likely to stay that way for a very long time.

Needless to say, the US$ carry trade is no longer working. For a start, the US$ is no longer falling, and borrowing US$ is no longer free (the Fed just raised rates again). In turn, this raises an important question: will the unwinding of the US$ carry trade prove as painful as the unwinding of the Yen carry-trade?

As our readers know, we have argued in recent months that the unwinding of the US$ carry-trade could lead to some short-term dislocations in the financial markets. However, so far this year, the US$ on a trade-weighted basis has risen +11% in a straight line, and the impact on financial markets has been mild. So have our fears on the effects of the unwinding of the US$ carry-trade been excessive?

One explanation for the good tenure of markets in the face of the US$ rally is that most investors short the US$ (save the ones who got in the game late) are still positive on their short US$ trade. Meanwhile bearishness on the US$ remains prevalent (i.e.: the belief in the "unstainability of the US current account deficit), and so panic has not yet hit the market.

This could of course change as central banks all over the world, except in the US, start to loosen monetary policy. Sweden and Poland have already cut interest rates by 50bp; and we believe that the UK, EMU & Australia should soon follow. As Charles put it in a meeting recently, this is the first cycle in his memory where the Fed is likely to be the last central bank to stop raising rates; and the last central bank to cut rates (if and when it does). The widening interest rate differentials alone should trigger an impressive US$ bull market.

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As this reality of the US$ bull market sets in, we will of course witness a change of behaviour in financial market participants. Will this change be a panic? Or will the change be a hunt for new opportunities? We use to believe it would be the former. We now believe it could be the latter. Indeed, all around the world, it is becoming increasingly obvious to investors that there is one currency which remains grotesquely overvalued, and whose interest rates can only go down: the Euro (though the AU$ also qualifies). So borrowing Euros to buy whatever else now makes a lot of sense. The US$ carry trade is in the process of being replaced by the Euro carry trade. This means, of course that we should expect the Euro to fall like a stone.


I hope you enjoyed this weeks Outside the Box. You can find out more about GaveKal and their research by going to

Your watching the carry trade analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 07-11-2005 2:44 AM by John Mauldin