Ad Hoc Commentary – Turkey’s possibly futile attempt to prevent the unwinding of the USD carry trade

“The Turkish central bank raised its overnight lending rate to 12% from 7.75%…”

Of course it stopped the rout of the Turkish Lira in the short term. By contagion, it also stabilized the whole of EM. But this is a very dangerous approach to say the very least. Have they considered what would they do when the USD carry trade continues to unwind in the medium term? Raise rates to 20%?

Let’s go back to first principle. A carry trade happens when there is a rate differential. Greed is myopic in nature, and thus, in a freely floating exchange rate regime, the carry trade is an almost certainty. Thus, when the differential is larger than a few percentage points, interest rate parity never holds, except by luck. It is a mystery why they keep interest rate parity on textbooks after the Bretton Woods system lost its gold anchor in 1971.

The biggest carry trade outstanding today is the USD carry trade. This is mainly driven by EM corporates borrowing in USD to do capital expenditure and/or investment (genuine and speculative) in their home countries. Some would argue that capex is not carry trade. But let’s face it: the biggest motivation for borrowing in US dollars to fund EM investment is because US interest rates are lower. Yes, we justify it with all sorts of factoids – revenues in US dollars, etc. But everyone seems to conveniently forget that some expenses like labor costs are bound to be in EM.

No country is immune from the carry trade. Even China with all her capital controls has corporates borrowing USD in Hong Kong, converting them into CNH, bringing them onshore via the CNH/CNY trade window (with proper documentation), and lending the CNY onshore. Granted the very lucrative China carry trade is not open to all, but like it or not, the smoke of USD carry trade has entered even the most iron-clad capital control regimes.

Mr Market had been doing the USD carry trade for so many years that we have a massive amount of USD being shorted in the markets. That is the elephant in the room. When the CFOs globally get scared of higher USD interest rates, and/or stronger USD, they pay back their USD loans. And they do that mainly by taking up EM loans to pay back those USD borrowings, i.e. sell EM buy USD. That is the main reason why USD strength will be a persistent trend into late 2015 as the Fed continues to taper. The few billions that the Federal Reserve is currently tapering and the plan to taper even more is peanuts. The real fear is the tapering becomes the catalyst that converts the current flow of US dollar carry trade unwinds into an avalanche of unwinds. The powers might probably believe that Janet Yellen can always reverse whatever tapering now-lame-duck Ben Bernanke started during the end of his term as Fed Chairman. Let’s hope they are right and we are not past the tipping point.

Good luck in the markets.