Carry Trade Meltdown

With most of the focus being directed at stock-and bond markets, few have noted the dramatic currency movements. To the extent currency movements have been noticed, it is usually with regards to euro/dollar and dollar/yen movements. Perhaps somewhat surprisingly, the dollar have risen against most currencies in response to the subprime meltdown-despite the fact that this is an American problem. Howerver, the dollar have fallen sharply against one currency-the yen. So, in essence, the previous currency trends where the dollar have fallen against most currencies but risen against the yen, have gone into reverse the last few weeks.

Indeed, the currencies that rose the most in previous months, such as the dollars of Australia and New Zealand, and the Brazilian real, have also been the ones that have fallen the most. The Aussie and Kiwi dollars have fallen roughly 10% and the Brazilian real roughly 13% against the U.S. dollar in a mere month.

But it gets even uglier if you look at the movement of the yen versus the Aussie and Kiwi dollars and the Brazilian real. The yen has risen 22% against the real in a month and 20% against the Aussie and Kiwi dollars.

Take a look at this chart, where we see the New Zealand dollar rise 25% against the yen in four months-only to fall 20% in less than a month. Can anyone seriously in light of that defend the Friedmanite assertion that floating exchange rates will move in relation to economic fundamentals?

But apart from its economic theoretical implications, these movements will further endanger financial stability in the world. With the massive carry trade, investors who borrow in yen and lend in Aussie and Kiwi dollars and real, there's got to be a lot of people who have lost a lot of money on this in the latest month. To some extent that will only mean Japanese households. But it could also mean more hedge funds.