What is Carry Trade?

Definition
The definition of carry trade from Investopedia is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. It is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency.

The Risk of Carry Trade
1. When the invested assets are declining sharply in price, carry trade investors should take risk.
2. Currency risk of invested currency will later be a burden. When the invested currency value tumbles, investor would have more deficit even thought the interest rates (rewards) are higher.

Japan is the best example of carry trade investment. Since natural disaster such as earthquake or typhoon is occurred frequently in Japan, indemnity insurance companies are obliged to compensate the losses. That is why Japanese investors were seeking for more gains, which later lead to FDI (Foreign Direct Investment) or foreign bonds. Recently, Japan is the largest net creditor country is the world. However, this kind of investment can negatively affect the economy.

For example, Japanese yen had reached about $1 trillion of carry trade investment due to its long low policy rate. However, when the global economy strikes to recession during 2008 financial crisis, the invested asset value was deteriorated. Japan started to sell off the foreign assets which is making Japanese Yen soars high.

It also happened during the worst earthquake (Kobe) in January 1995. Japanese Yen has tumbled until 1USD = 80JPY, due to withdrawal against carry trade investment. It was only 5 years after Japanese asset price bubble blasted, Japan had the worst domestic economy, troubled with insolvent assets. However, due to strong Japanese currency value, their exported started tumbling, making their economy go even worse. About 4 months later, Japan agreed to have anti-Plaza agreements, leaving Japanese Yen weakening its value.
(South Korea attempted to expand more on Capex investment since Japan had hard time with high JPY. They might have took it as great opportunity for their export. Unexpected anti-Plaza accord was one of the reason that lead South Korea in currency crisis.)

Stocks close lower despite the fall of unemployment rate? "Good is Bad"

U.S stocks slides amid the good news of declining unemployment rate. Why can it be possible? In Morning Brief session from Global Monitor mentioned a phrase, "Good is Bad". The good news can be bad news.

According to Department of Labor, initial jobless claims decreased to 963K from 1,191K ending a 20-week streak of results above 1 million. However, investors are concerned if job gains recovers, fiscal booster of giving extra $600 (stimulus package) will decline.

 

The S&P 500 has flirted with record levels in recent days but ended Thursday’s session down 6.92 points, or 0.2%, at 3373.43, still within 0.4% of its Feb. 19 record. The Dow Jones Industrial Average dropped 80.12 points, or 0.3%, to 27896.72, while the tech-heavy Nasdaq Composite index rose 30.27 points, or 0.3%, to 11042.50.

The yield on the 10-year U.S. Treasury note ticked up for the fifth straight session, to 0.714% Thursday from 0.669% a day earlier amid weak demand in a $26 billion auction of 30-year bonds. (Bear Steepening: 30-year bond yield has climbed due to less than expected demand for Conversion Issue)

In commodities, gold rose 1.1% to $1,956.70 a troy ounce as the volatility seen in recent days continued. “We keep gold because there are still uncertainties, real rates are low, inflation may be higher than expected,” said Luc Filip, head of private banking investments at SYZ Private Banking.

According to Professor Jeremy Siegel, bond yields will go higher in 2 or 3 years due to inflation. Investors will not seek for safe-assets, which means they will find riskier assets that compensate by providing higher returns. Inflation hedge assets such as Gold or TIPS can be one of them, stocks or high yield corporate bonds will be another.

Source 1: Weekly Unemployment Claims Drop Below One Million for First Time Since March
https://www.wsj.com/articles/unemployment-benefits-weekly-jobless-claims-coronavirus-08-13-2020-11597280120?mod=hp_lead_pos3

Source 2: Stocks Close Lower Despite Fall in Jobless Claims

https://www.wsj.com/articles/global-stock-markets-dow-update-8-13-2020-11597310515?mod=markets_lead_pos1

Source 3: Global Monitor Morning Brief

Source 4: I think we're going to have a spending boom in 2021: Wharton finance professor
https://www.youtube.com/watch?v=4oTFgqCXcyY

What is the 'Dollar's Smile'?

Brief explanation about Dollar's Smile.
U.S dollar tends to increase in value when the world economy is extremely weak or U.S economy becomes exceptionally stronger than other countries.
Suppose that there is a straight line. Two factors I mentioned above are at the end of the line which drags it upwards. Then the middle point would be relatively low which makes the figure looks like a smile. Let me give you three examples that influence on the moves of U.S Dollars.

1. When the U.S. economy is weak.
During the lowest bottom of real economy when the number of COVID-19 confirmed cases has spread, US Dollars became relatively stronger than other currencies. It is due to the increase in investors who are looking for the safest securities. Secured assets are mostly in U.S, so investors borrow or exchange into the dollars. Dollar's value surge up consequently. In extremely worst cases, investors withdraw cash from the safest assets such as U.S treasuries, which makes currency precious. (Cash is very important to compensate margin for leveraged loans. Margin calls are the most frightening signals for investor in risk of liquidation from investment bank.)

2. When U.S economy is stronger than other countries.
In fact, there are two cases that drive demand for U.S dollars. First, when U.S stock index rallies, investors all around the world will try to borrow dollars to buy the risky assets. When the economy overheats, FED will likely to increase FFR (Federal Funds Rate), which will look treasury bond attractive as yield increases. (Chance to buy bonds at relatively cheaper price) Recent days during FOMC, Fed announced to remain interest rate low until the inflation rate overshoots above 2% target.

3. When global growth especially on emerging countries strengthens.
Investors are on risk-on mode during the season when growth on global market boosts. Investors will look for more risky assets to have more capital gains and profits. Investors will sell safe-haven assets such as treasuries (bond, note, and bills) and exchange into risk currencies.

FYI: US dollar becomes strong during recession in US for two reasons.

1. When U.S consumption economy drop, then their import drops. This will lead to trade deficit drop. Supply of Dollar will drop which affects surge in USD.

2. U.S banks or financial institution will secure cash, which will lead to damage on carry trade investment. (In case of bank run) When U.S withdraws cash, then USD will be stronger. Other countries will suffer due to foreign exchange outflow.

Source 1: What Is the Dollar’s ‘Smile’?
https://www.wsj.com/articles/what-is-the-dollars-smile-11591539293#:~:text=The%20dollar%20smile%20is%20a,the%20smile%20on%20your%20face.

Source 2: Fed’s Kaplan Open to Overshooting Inflation Target to Provide More Support
https://www.wsj.com/articles/feds-kaplan-open-to-overshooting-inflation-target-to-provide-more-support-11594995860

U.S. Treasury yield recovers, challenging gold and silver's rally

U.S. Treasury yield rose on Wednesday in the NYSE bond market to 0.669% for the fourth straight session.

The yield's climb can be considered as the reason below.
1. Consumer Prices(CPI) and Core CPI(excluding foods and energy) each surged for 0.6 percent in July, the same increase as in June. Here is brief explanation of CPI from Investopedia.com. "The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them."

2. It was triggered by bond dealers' offering of new bonds, with their holdings and fund managers leaving room in their portfolios.
3. The decline in trading volume during the summer vacation season in the U.S. and Europe is also likely to have contributed to the decline.

The rise of treasury yield has curtailed investors's appetite of craving for Gold and Silver, which means that cash looks more attractive.

Source 1: Treasurys Stabilize After 10-Year Note Auction

https://www.wsj.com/articles/investors-shun-treasurys-ahead-of-massive-debt-sale-11597238313#:~:text=U.S.%20government%20bonds%20came%20under,of%20new%2010%2Dyear%20notes.&text=That%20marked%20a%20turnaround%20for,near%20record%20lows%20below%200.6%25.

Source 2: Rising Treasury Yields Challenge Precious Metals Rally

https://www.wsj.com/articles/gold-falls-on-likely-profit-taking-11597199510

Source 3: Consumer Prices Surge Again, Core CPI Jumps Most Since 1991
https://www.thestreet.com/mishtalk/economics/consumer-prices-surge-again-core-cpi-jumps-most-since-1991

Can Gold and Silver be considered as safe-haven asset or great hedge against inflation?

Gold and silver have been attractive asset to the investors recently as the central bank policy interest rates have been low after the emerge of COVID-19. It is considered as 'must have' assets among Robinhood due to their portfolio diversification.

In WSJ article, Jason Zweig calls Gold as yellow metal. Gold looks cheap for investors since they regard gold as extremely safe-assets. This ETF related to gold this year values nearly $215 billion; which is about 2 time more than a year ago. Around one-fifth of cash inflow to the gold asset has been made since January 1st 2020 as reported by World Gold Council.

Gold itself do not go up or down in its own value. The value of gold is relatively determined by the interest rate of cash. That means if Federal Fund Rate is set to be higher, then the value of cash follows that. (Interest rate means price of cash) If cash value increases, then the price of gold becomes relatively low. Gold shines brightest when the phase of inflation soars up due to devaluation of cash.

So investor regarded gold as 1. great hedge of inflation and 2. safe-haven assets. If economic downturns take place, people will look for gold. It makes sense however, not always. If the price of gold becomes relatively higher than other assets, then the price might fall due to the overheat of it.

I do not think gold and silver as very attractive assets than the stocks or bonds since it has storage cost, however produces no income like dividend or coupon(yields). The price of gold is also very uncertain against the economy. When economy recovers up and central banks pushes interest rate higher, then it will hurt gold. 

The similar characteristic asset that gold have would be TIPS (Treasury Inflation Protection Security).

However, I do not raise any problems about the possession of gold for the investment diversification.

Source 1: A Golden Rule From a Golden Fool
https://www.wsj.com/articles/a-golden-rule-from-a-golden-fool-11595599207

Source 2: Silver vs. Gold: How the Two Metals Compare as Investments
https://www.wsj.com/articles/silver-vs-gold-how-the-two-metals-compare-as-investments-11596899825

Source 3: Why Gold Prices Are Hitting All-Time Highs
https://www.wsj.com/articles/why-gold-prices-are-hitting-all-time-highs-11596533550