Clarification On Carry Trade

In my theoretical reasoning regarding why carry trade is in fact profitable, I argued for it from the perspective of the text book scenario on why uncovered carry trade can't be profitable. Namely, because traders knowing about the interest rate differential will trade up the value of the currency with higher interest rates to such a high level that it can be expected that the currency will depreciate in the future enough to make the difference in exchange rate adjusted return disappear.

Since that is the scenario usually presented in international economics textbooks and classes, I still think it was right of me to focus on that. However, in hindsight I think I should have also clarified that the incompatibility of the purchasing power parity theory and the uncovered interest parity theory in a world where real interest rates differ does not depend on the initial adjustment taking place.

Assuming that the initial adjustment process, where the exchange rate of the high interest rate currency initially becomes overvalued from a goods market perspective, initiates, then the increased demand for goods from low interest rate countries will also increase the demand for their currencies, thus preventing the full initial appreciation of high interest rate currencies needed to create the expectation of future depreciation of high interest rate currencies needed to equalize return.

Suppose however, that no initial adjustment takes place, can the incompatibility of the purchasing power parity theory and the uncovered interest parity theory still be relevant? Yes, because in order for return to be equal, countries with higher real interest rates must still see their currencies depreciate in real terms. If the high interest rate currency wasn't overvalued to begin with, this means that it will become more and more undervalued as the years pass by. As a result, demand for goods in high interest rate countries will increase as the years pass by, which also means that demand for that currency gradually increases. That in turn will prevent or at least limit the gradual depreciation needed to equalize return.

This clarification has little theoretical importance except in one aspect, namely that it doesn't necessarily mean that high interest rate countries will empirically see net exports decline (see trade deficit increase or trade surplus drop). If the initial adjustment does not take place, it could in fact mean that net exports increases.

New Zealand To Propose Fiscal Austerity To Reduce Trade Deficit?

A reader asked me to comment on this article in the New Zealand Herald. Some economists at the Treasury in New Zealand argues that if New Zealand would tighten fiscal policy this would lower interest rates, something which in turn would weaken the exchange rate something which in turn would reduce the trade deficit in New Zealand.

They are right insofar that fiscal austerity will indeed reduce interest rates and also reduce the trade deficit in New Zealand. The reduction in the trade deficit will be lower than the reduction in the budget deficit (it is not so to speak any "identical twin deficit relationship"), but it will clearly reduce the trade deficit.

That reduction will because of New Zealand's floating exchange rate system in part be the result of the lower exchange rate of the New Zealand dollar caused by lower interest rates. "Autonomous" shifts in interest rates will have a more ambigous effect on the trade deficit, but a reduction caused by higher government savings will unambigously reduce the deficit.

However, while their theoretical predictions are basically correct, the terms used indicate that they probably exaggerate the net value of these effects for New Zealand.

The reader indicated that he wanted to know the investment implications of this. Well, such a move will likely reduce real interest rates something which as I explained in the previous post makes investments in New Zealand dollar denominated securities somewhat less attractive. However, New Zealand has had higher interest rates before even during times of budget surpluses and they will likely continue to have structurally higher real interest rates, even if the proposed strategy is implemented.

Why Carry Trade Is Profitable In The Long Term

I have hinted or mentioned explicitly several times before (for example here, here and here), high interest rate currencies tend to give a higher return than low interest rate currencies. I will now elaborate on this issue.

In my own compilation of returns for investors (based on 3-month interest rate data from the OECD web site and exchange rate data from the Federal Reserve web site) in the 25 year period between 1984 and 2008 (more strictly between December 31, 1983 and December 31, 2008), investors in the three highest yielding developed countries, New Zealand, the U.K. and Australia got a cumulative return of 885% (9.6% per year), 525% (7.6% per year) and 488% (7.3% per year). By contrast, investments in the three lowest yielding developed countries, Japan, Switzerland and the United States gave the far more lackluster cumulative returns of 371% (6.4% per year), 376% (6.4% per year) and 264% (5.3% per year).

The carry trade strategy of investing in high interest rates countries while not investing (or even borrowing) in low interest rates countries yielded even better results if portfolios shifted each years depending on which countries had high interest rates that year (United States for example had relatively high interest rates in the late 1990s, but had low interest rates after the Internet stock bubble ended). In that case, the average return of the high interest rate countries was a cumulative 795% (9.2% per year) while the average return of the low interest rate countries was just 285 %( 5.5% per year).

Since the currencies of the two countries with highest interest rates among developed countries right now, Australia and New Zealand, has appreciated dramatically this year, the results will probably be even clearer when data from this year is included.

According to the uncovered interest rate parity model taught by universities in international economics classes, these differentials shouldn't exist. But they do, meaning that the model is at least partially false.

The reason for why it is not true is that as I pointed out here, it is not consistent with the purchasing power parity model in a world where real interest rates differ. Remember, exchange rates are determined based both on goods market transactions (which the purchasing power parity model deals with) and asset market transaction (which the uncovered interest rate parity model deals with), and if high interest rate currencies become initially overvalued in goods market terms in accordance with the scenario necessary for the uncovered interest rate, then demand for goods produced there will fall, preventing the currency from rising sufficiently in value for uncovered interest rate parity to hold.

Today's international economics classes fails to integrate theories related to goods markets and capital markets, even though both are involved in determining exchange rates in the real world.

To illustrate these abstract theories with a specific example, assume for example that Australia and Japan have nominal interest rates of 6% and 2% respectively, and assume that inflation in Australia is 2% and 0% in Japan. In order for interest parity to hold, the Australian dollar must on average depreciate by nearly 4% per year against the yen. Since there is a 2% inflation differential, the real depreciation of the Australian dollar has to be 2% per year. To create the expectation of such depreciation, the Australian dollar must now become at least 22% overvalued in terms of the goods market equilibrium. But if the Australian dollar started to become that overvalued then demand for Australian goods, and the Australian dollars needed to buy them, would drop, preventing the necessary Australian dollar appreciation. The initial shift in capital market demand for Australian dollars needed to create the conditions that would make the uncovered interest rate parity theory true will then to some extent be counteracted by goods market actions. As a result, the long term return for investors in countries with high (real) interest rates will be higher than in countries with low (real) interest rates.

Note however that in case high interest rates simply reflects high inflation, then it will not give you a high return, as people who invested in securities denominated in for example Icelandic krona and Zimbabwean dollar are painfully aware of.

And also note that the strategy is not entirely risk free in the short term. Some years, like in 2008, the carry trade strategy will inflict losses on those who follow it. But other years (like likely 2009) the return will be extraordinarily good, and if you have a more long term perspective it will generate higher returns for you.

Coincident Indicators Drop Again

While this is near universally ignored by the financial media who only look at the leading indicator index, the coincident indicator index dropped again, albeit only slightly, for the second month in a row.

The coincident index is made up of nonfarm payrolls, real disposable income excluding transfer payments, real business sales and industrial production. When determining how the economy doing right now, the coincident index is the one to look at. And with the coincident indicator index dropping, the strength of the so-called recovery can again be called into question.

Note however that the Conference Board who compiled the index probably understimated the declie. Only nonfarm payrolls and industrial production are yet known, so they have to impute the values for real disposable income excluding transfer payments and real business sales, something they do with an "autoregressive" model. That model has however severe limitations as it doesn't uses common sense analysis of data which can indicate that value (such as CPI and the employment report), but instead analyses past values to estimate current values. As such it often fails, like it did last month when the model predicted an increase in real disposable income excluding transfer payments, while in reality it decreased. Now it again predicts an increase (even with that estimate the overall index still dropped because of the big decrease in nonfarm payrolls), even though labor market data indicates another decrease.

Paul Krugman On Chinese Currency Policy

Before I continue, I should immediately say (to pre-empt misunderstandings) that I think China should make the yuan stronger. Not however, for the reasons most pundits argue but rather because China needs to rein in the obvious inflationary excesses of their current boom, and currency appreciation would be one way of achieving that.

And furthermore, yuan appreciation would reduce the political pressure for barriers against Chinese imports.

However, the arguments used by many pundits to argue for Chinese currency appreciation are very misleading and dangerous. Case in point is Paul Krugman's latest column. Almost all of his columns and blog posts contain errors, and I don't have the time or will to try to correct them all. But the latest one was unusually misleading even for being Krugman.

First he writes:

"Some background: Most of the world’s major currencies “float” against one another. That is, their relative values move up or down depending on market forces. That doesn’t necessarily mean that governments pursue pure hands-off policies: countries sometimes limit capital outflows when there’s a run on their currency (as Iceland did last year) or take steps to discourage hot-money inflows when they fear that speculators love their economies not wisely but too well (which is what Brazil is doing right now). But these days most nations try to keep the value of their currency in line with long-term economic fundamentals.

China is the great exception."

First of all, while it is true that today, most major currencies float against each other, quite a lot of countries throughout the world pegs their currency against other currencies (Usually the U.S. dollar or the euro), including for example Hong Kong, Saudi Arabia and a lot of European countries. And during many periods in world history, for example during the classical gold standard or during the Bretton-Woods system, fixed exchange rates have been the rule. Fixed exchange rates are in other words definitely not something the Chinese just came up with, it was the standard system for most of the time since start of the Industrial Revolution.

And since exchange rates aren't affected by just direct measures to affect the exchange rates, but also by for example interest rate policy, floating exchange rates aren't really market based. Only a pure gold (or other commodity) based currency can be entirely market based.

Nor are they ruled by "economic fundamentals" (whatever that is supposed to mean), as is evident by for example the fact that weak economic reports in America usually leads to a stronger dollar (and that stronger reports usually leads to a weaker dollar).

Furthermore, while the yuan may be pegged to the U.S. dollar, it has in fact been floating against all other currencies (well, except others that are pegged to the USD) in the exact same way as the USD. The yuan appreciated dramatically late last year and early this year against most currencies, and has since depreciated against most currencies.

Moving on to the next paragraph:

"And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters."

What Krugman overlooks is first of all that the dollar, and also the yuan, is still generally stronger than when China ended the yuan's appreciation against the dollar, meaning that compared to the beginning of that policy shift, the yuan has appreciated against most currencies.

And secondly, and more importantly, because the dollar and the yuan have moved up and down in the same way, any accusation against China holds for the United States as well. If China has pursued a "beggar-thy-neighbor devaluation" policy then so has the United States.

Krugman later discusses the recent increase in the trade deficit:

" Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge.

That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”

Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.

But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines."

Krugman tries to imply that the great drop in the trade deficit was simply a matter of falling trade volumes, but that is not true. Between May 2008 and May 2009 (the month with the lowest trade deficit) exports dropped 21% and imports 31%. The truth is that the drop in the trade deficit reflected the sharp drop in domestic demand.

And similarly, the increase in the trade deficit since then reflects largely the effect of the so-called "stimulus package". While Krugman's Keynesian models won't recognize that fiscal stimulus will reduce net exports (meaning increase trade deficits in the case of America), that is what happens in the real world, reducing the so-called "fiscal multipliers" significantly below the fantasy levels indicated by Keynesian models. And in case you wonder, trade barriers wouldn't really improve thse "fiscal multipliers" because while it would reduce the trade deficit increasing effect, it would on the other hand increase the price increasing effect.

So, while a stronger yuan would be in China's best interest because it would contain domestic inflation and foreign protectionism, it wouldn't help improve the American economy or job market.

Housing Starts, Real Wages Drops

Two data was published today that confirmed that the U.S. economic recovery is anything but robust.

First, housing starts and to a lesser extent building permits dropped sharply in October, indicating that the big increase in residential construction in the third quarter was only temporary.

Secondly, the seasonally adjusted consumer price index increased more than 0.3% in October. As a result, real wages dropped slightly. Combined with the drop in employment, this means that aggregate real labor income (and therefore probably also the key coincident indicator real disposable income excluding transfer payments) fell in October.

Considering that rents fell slightly again (probably because of the mechanism discussed here), a 0.3% increase in the CPI is incidentally particularly significant and indicates a stagflationary trend.

How "Stimulus" Increases Unemployment

Alan Reynolds explains it here. Note how Obama economic advisor Larry Summer's previous writings are used against the policies of the Obama administration, just as in the issue of whether a health insurance mandate should be considered a tax [increase].

U.S. Industrial Capacity Drops

U.S. Industrial production rose 0.1% in October, far less than most economists had expected, following 3 months of more solid gains. Manufacturing alone declined, as did mining, but that was more than compensated by gains in utilities (electricity) production).

One detail that no one, as far as I know, in the financial press has discussed is that in recent months industrial capacity has dropped. The drop is biggest in manufacturing but can also be seen in mining (utilities capacity is still growing, but at a slower rate than last year) As a result, capacity utilization has increased faster than production.

In October 2008, manufacturing capacity was up by 1.8% while mining capacity was up 0.7%. In recent months however, these numbers have turned negative, and in October 2009, manufacturing capacity had dropped 1% while mining capacity was down 0.6%.

These annual declines will likely be even greater in coming months since first of all the level of business investment is low and secondly because much of the current capacity reflects previous malinvestments and can only produce products which people don't demand any more. As that capacity is written off, official industrial capacity will decline further.

Falling industrial capacity will have a stagflationary effect on the economy as it will both limit production and increase the willingness of remaining producers to raise prices as potential supply and therefore also potential competition is reduced.

European Rebalancing Continues

The Euro area trade surplus was €3.7 billion in September 2009, compared to a €6.0 billion deficit in September 2008.

This happened despite the fact that Germany saw its surplus drop to €10.6 billion in September 2009, down from €15.3 billion in September 2008.

This means that the deficit for the rest of the Euro area dropped from €21.3 billion in September 2008 to just €6.9 billion in September 2009. As other surplus nations like Holland, Austria and Finland also saw their surpluses drop, this reflects a really big reduction in the trade deficits of countries like France, Italy, Spain, Portugal and Greece.

Not So Strong Japanese Recovery

The Japanese Cabinet Office today reported higher than expected quarterly real GDP growth of 4.8% at an annual rate in Japan, something which contributed to the global stock rally today.

Yet they also reported that nominal GDP growth was -0.3% at annual rate, meaning that the 4.8% real growth number assumed deflation as high as 5.1% at an annual rate. While the general price level arguably is falling in Japan, it is not plausible that it dropped that much between the second and third quarter. Indeed, the domestic demand deflator reported only 1.3% deflation, meaning that terms of trade adjusted GDP rose just 1% at an annual rate. This number is roughly in line with the 0.8% reported increase in gross domestic income.

In previous quarters, the terms of trade factor caused the decline in GDP to be exaggerated, and that is in fact also true for the four quarter (one year) change. But while output in Japan never dropped as much as headline GDP numbers suggested, the current recovery is also a lot weaker than the headline GDP number suggest.