Dollar Carry Trade and Positioning

Three important developments to note:

1. In our discussion with clients and policy makers over the past 3-6 months we argued that one of the potential surprises that few were prepared for was a stronger dollar. The Deputy Governor of the PBOC was quoted from Davos making a similar assessment. "To me, the big risk this year is the dollar carry trades. It is a massive issue. Estimates are that the dollar carry trade is $1.5 trillion, which is much bigger than Japan's carry trade was."

2. The Commitment of Traders at the the IMM showed a large jump in long dollar exposure among the non-commercials (speculators). Specifically, through last Tuesday (Jan 26), the net short euro position had been extended to almost 40k contracts from 25.3k the previous week. Given the subsequent price action and interpolating from open interest, it would not be surprising if this week's data showed a record net short euro positions. Net short sterling positions increased by almost a third to 27.2k contracts. Swiss franc net longs were cut by more than half to just below 6k from 14k.

The one main exception was the Japanese yen and here net short positions were cut by three-fourths to 4.3k. The other currency futures saw the net long exposure slashed in face of the dollar's momentum. CAD longs were cut to 25.8k from 46.8k, while Australian dollar longs were reduced to a still strong 45.3k from 62.8k. Lastly, the Mexican peso longs were cut to a little more than 58k from a little more than 79k.

3. EPFR reports that for the week ending Jan 27th, emerging market equity funds saw the first net outflow in 12 weeks. The only regional exception was non-Japan Asia, including Chinese funds, which saw their first inflow since mid-December. Nevertheless, the BRIC funds as a whole recorded a net outflow for the first time since early Sept 09.

MSCI EM Index has fallen a little more than 10% from last month's peak. Investors have become concerned about the earlier than expected tightening (reserve requirement in China and India and higher bill rates too in China). Rising inflation pressures in Brazil has spurred some speculation that it could lift rates as early as next month. While this is possible, we suspect April is a more likely time frame, but in the big picture, the direction is clear. Russia stands out as the only BRIC still in a rate cutting mode.

Bottom Line: Estimates of the dollar carry trade need to be taken with a large grain of salt. While speculators in the futures market are short euro at record levels and has trimmed short US dollar positions, we suspect that the medium and longer terms investors are slower to reverse structural positions. The dollar's recent strength appears to be more a function of bad news overseas (European credit woes, early tightening of monetary conditions in China, India, etc) than good news in the US. While the US economic data shows a recover is still unfolding, expectations for Fed tightening have not been brought forward. The slowing of flows into emerging markets seems to be a response to the early tightening and profit-taking on last year's dramatic run up. It is weighing on many of the regional currencies and from an official point of view is a wholly desirable development--as long as it does not turn into a rout.