The “carry-trade” is a trading, investment or hedging strategy that involves borrowing funds in a low-interest rate market and purchasing an offsetting position (e.g., bond investment) in a high-interest rate market. By borrowing in one currency at low interest rates and investing in another currency with higher interest rates, one can secure a positive return -- unless exchange rates move adversely. An example of a "U.S. Dollar carry-trade" is borrowing U.S. $1 million from a U.S. bank at, say 1.30%, exchanging the funds into Pound Sterling, and buying a U.K. bond for the equivalent amount, earning 4.50%. Assuming that the U.K. bond pays more than the amount one has to pay the U.S. bank for borrowing the Dollar’s, one will earn a net-return, as long as the exchange rate does not move adversely.

The same opportunity and effect can be mimicked by exploiting the forward bias of a currency. Sustained low interest rates in the U.S. have afforded importers the advantage of buying (hedging) high interest rate currencies "cheaper" in the forwards. For example, the spot Pound Sterling/Dollar rate is currently around $1.8125, but a 1-year forward exchange (FX) rate is around $1.7555 -- 570 FX points lower, due to the 320-basis point interest rate differential in favor of the Pound Sterling (note: these are mid-market indications).

Since last fall, the U.S. dollar has largely played the role of a "funding" currency in carry-trades, while currencies like the Pound Sterling, Aussie and Kiwi have led the charge for the so-called "high yielders," and pulled along surrounding currencies like the Euro and Canadian dollar to some extent. In recent weeks, however, the central banks -- which control the level of key short-term interest rates -- of the U.K., Australia and New Zealand have notably backed away from their hawkish biases (to raise interest rates); each one passed on an opportunity to hike key interest rates at its respective policy meeting. Meanwhile, the Bank of Canada has eased interest rates twice already this year, and now appears more "dovish" than at any point in the past two years. The European Central Bank is under increasing political pressure to ease.

What all this points to is a less certain environment now for investors, speculators, and traders to either enter or renew their Dollar carry-trades or similar strategies aimed at exploiting the Dollar’s low interest rates. And despite the fact that the U.S. yield curve is flattening (long-term interest rates are collapsing), the core catalyst for high-yield currency out-performance – “hawkish” foreign central bank monetary policies -- appears to have dwindled. Therefore, we look for the U.S. Dollar to generally stabilize in value over the next several weeks. The Dollar’s long-term bear trend may not re-emerge for several months.

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