The following is a guest contribution from Annaly Capital Management:

In financial journalism, sometimes certain words and phrases catch on and get overused to the point of nearly stripping the meaning from the word (we present “green shoots”).  The phrase du jour is “carry trade”.  The idea is by no means new, but it’s relatively simple:  investors borrow in a lower rate currency and lend in a higher rate currency.  We used to hear about the Yen carry trade, but thanks to the zero interest rate policy of the Federal Reserve, it’s now the US dollar carry trade.  The current go-to trade is shorting the US Dollar and buying Australian Dollars.  Forgive us the following technical explanation.  The difference between 3 month rates in the US and Australia is roughly 4% annualized, so if you buy the 3 month futures contract selling USD and buying AUD, you pick up the forward drop (currency trader lingo for the expected fall in the exchange rate of the higher yielding currency) immediately in your contract price.  If there is no change in the exchange rate between the USD versus the AUD, you just made an annualized 4%.  The worst case scenario for this trade is dollar strength, because just 4% depreciation (on an annualized basis, at that) of the AUD versus the USD wipes out your profits.  Conversely, USD weakness is just icing on your carry cake.  Below we see the YTD performance of the USD/AUD.

Thanks to the ever-falling dollar, if you had put this trade on at January 1, 2009, you have a juicy return somewhere in the high 20%’s.  Even more if you are levered.

So, if this is the gimme trade of the century who is taking the other side?  After all, for every seller of dollars there must be a buyer.  The answer seems to be central banks, particularly those with USD pegs and those who are just outright manipulating their currencies in an effort to keep them competitive.  The most obvious would be China, who allowed their currency to float for a few years (not a real free float, of course), but quickly put the brakes on that plan in mid-2008.

It’s no surprise that, since the stabilization began in mid-2008, China’s holdings of Treasuries (despite ultra-low yield, and poor dollar fundamentals) have increased roughly 60% in just a little over a year (from near $500 billion to $800 billion).  Being a forced buyer of dollar-based, low-yielding assets is a tough row to hoe, but apparently it’s better than the alternative for China:  a strong Yuan, making their manufactured products relatively more expensive to the rest of the world.

Source: Annaly