Gold News

Gold & the Carry Trade

Gold Prices are rising on a tide of instability in the global carry trade...

to see that the Gold Price has not only been reacting to the absolute levels of the oil price and the fall of the Dollar, but to the instability, uncertainty and downright fear in the capital markets and the banking system.

   Two reasons why there is such drama has been the activities of the "Carry Trade" and the resultant capital tsunamis, or even the complete lack of available capital, much as the shoreline pulls right back before the Tsunami hits.

Gold & the "Carry Trade"

One wrong picture we must correct is that it is Japanese housewives who are behind the carry trade. This is a cute but ridiculous concept.

The carry trade is a group title for a type of trading carried on all over the world where interest rate differentials allow borrowing in one currency to lend in another. Any currency trader anywhere in the world can do this as he has the requisite standing with the banks.

The bulk of these traders are housed in massive dealing rooms in the vast majority of the banks in the world. These operations may sound simple on the surface, but in reality can be difficult to assess accurately and even more difficult to execute. The currency traders at the world banks and they watch their screens every moment, moving and trading with every change in exchange rates, closely in touch with in-house research.

These are clever young lads; working for their annual bonus with an eye on the latest Porsche. They have enormous financial power, but are held on a tight leash by their bosses.

The carry trade concept comes with exchange rate risks, which are part of the assessment of potential profits. The Yen was ideal because it was relatively stable against the US Dollar until recently after a weakening trend over the last year as it fell from around ¥100 to the Dollar to ¥122 per Dollar.

Then, in the last month, the Yen turned viciously onto a strengthening trend, taking it back to ¥109. The question now is will the Yen weaken again? If it does then the carry trade opportunity reappears.

But to even think that only the Yen has to be part of this business is again naïve. The speed of the change in the Yen’s value was probably precipitated by these traders as they saw the dangers of a Yen strengthening and a Dollar weakening.

What would you do in that position?

Why, close out your borrowing in Yen and open it in the Dollar, where interest rates and the exchange rates turned down. If you had lent into the New Zealand Dollar or the Australian Dollar or even the Euro, and you would hold that position, setting it against the US Dollar.

With a strengthening of the Yen, you wait until it peaks (in your opinion) then reopen your borrowing in Yen and close it in the US Dollar.

These are short-term traders who like positions to hold as long as they can to maximize interest income, but stay nimble on their toes, grabbing each opportunity as it rises and closing positions in a heartbeat. At times working these desks can be as exciting as driving a Ferrari. No wonder these Traders are burned out by the time they reach 40. They contribute heavily to the creation of massive capital flows that create the rising volatility in the markets that we are seeing right now.

Combine these with other Soros like traders alongside genuine investors like sovereign wealth funds, you not only have potentially massive capital tsunamis, you have a very real precipitant for much more uncertainty and instability. One crack in the hull of the global monetary system and the capital will flood out or in.

The Capital Tsunamis Won't Go Away

Using the Dollar to pay for purchases of currencies with higher yields is proving to be the most profitable trade in the foreign-exchange market amongst the carry trade.

A basket of currencies including the British Pound, Brazilian Real, and Hungarian Forint financed with Dollars returned 17% this year, compared with 9% when funded in the Yen and 7% in Swiss Francs. Falling US interest rates and increasing volatility in the Yen and Franc are making the trade even more appealing. With the Dollar giving the appearance of being in free fall, it increases the attractiveness of using the currency to fund investments.

The last time the US Dollar was used for so-called carry trades was in 2004, when the Federal Reserve's target rate for overnight loans between banks was 1%. Since then, it has weakened 18% on a trade-weighted basis. The International Monetary Fund says the Dollar made up 64.8% of central banks' currency reserves in the second quarter, down from 71% in 1999, after the Euro was introduced.

Investors are borrowing the Dollar and using the money to buy assets in countries with higher interest rates even though US borrowing costs are 4% points more than the Bank of Japan's and 1.75% points above the Swiss National Bank benchmark. Investors may switch more than $100 billion of borrowing from Yen or Francs into the Dollar in the next two years for carry trades.

The value of futures contracts held this month by hedge funds and traders betting against the Dollar was a record $33.9 billion more than contracts that profit from a gain. Pacific Investment Management Co., which oversees the world's biggest managed bond fund, is selling Dollars against the Brazil Real, Mexican Peso, Korean Won, and Singapore Dollar.

"When we think about currencies on a three-to-five-year basis we're very bullish on emerging markets versus the US Dollar," said Pimco. "That view is only reinforced when you look at interest-rate differentials."

The Brazilian Real rose 18.5% this year and Singapore's currency strengthened 6.4%, while the Won was little changed. The Mexican Peso fell 1.4%, the only one of the 16 most-traded currencies to do worse in the foreign exchange market.

Using a currency to finance trades does drive down its value as we saw in the exchange rate of the Yen. Former Japanese vice finance minister Hiroshi Watanabe said in May that one reason the Yen had fallen to a record low against the Euro was because it was funding about $500 billion of carry trades.

All in all, the above information confirms that carry trading is here to stay and getting bigger and bigger. It is a large contributor to the volatility of exchange rates and financial ruptures in the world money system. It is "hot money" and likely to fuel speculation against vulnerable currencies.

The instability and uncertainty such trading fuels will continue to make gold more and more attractive and the foundation of paper money more and more fragile. When one hears the Fed Chairman reflect this atmosphere, you just know some will seek the safety of Gold Investment, at least. But some will become many as instability and uncertainty is reflected in many market places.

Shortly in our pages at we will be covering just how "Marginal Supply" and "Syndications" have also contributed to the instability and uncertainty has and will contribute to making Gold Investment attractive in the short, medium and long-term.

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JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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