Carry trade, false alarm?

A popular currency strategy, notably amongst hedge funds, carry trade have been a goldmine for investors hungry for yield. Following this strategy, investors borrow money from a cheap currency, such as the yen, and invest in a currency that offers higher interest rates. For exemple, an investor borrow 1M yen, sells those yen to buy 10 000 $, and then invest in US treasory bonds, offering 4% yield whereas the interest rate is near to 0 on the yen. As a result, the investor profits from the spread between the two interest rates. However, a dollar fall could jeopardize the return and bring huge losses.

Those higher rates paid by countries receiving the cash flow of carry trade can come from a large external deficit. Take US' example : imports exceeding exports, the selling pressure is strong on the dollar, hence the government offer higher interest rates on bonds to compensate the risk of currency depreciation. On the other hand, Japan has a strong external surplus, hence offering low interest rates.

Carry trade has a collateral effect on the economy of countries benefiting from the cash inflow : investor buying dollars to pile in government bonds, the inward pressure keeps the dollar high, which keeps imports cheap, and at the sime time bring the exports down. A few months ago, a lot of people were worrying that a carry trade collapse (for example caused by a strong increase of the yen) could bring currencies of all emerging markets down, pushing oil even higher, and breaking the equilibrium of global economy.

This paradox has been illustrated on the first half of 2008. Risk aversion has dried carry trade money. Consequently, the selling pressure on the dollar has prevailed, pushing the currency down and increasing the oil prices. But on august 2008, it has been revealed that thanks to the cheap dollar, US exports have boomed, GDP growth forecast being re-assessed to more than 3%, nothing similiar to the recession talk that have been thrusted forward since early 2008.

Now, doom-tellers have left the carry trade talk, the health of the banking system seeming like a more important thing to worry about.

So, carry trade, false alarm?