Get Ready for the Dollar Carry Trade

Now here’s an idea. Borrow money from the Fed at almost nothing. Turn around and lend the money to the U.S. government. The government finds a way to finance its deficits. The banks benefit from the yield pickup. Everybody happy. Get ready for the dollar carry trade.

There’s no question that the Fed is flooding the banking system with cash. As can be seen in the St. Louis Federal Reserve’s report “Aggregate Reserves of Monetary Institutions” the banks are hoarding this cash. The excess reserves (the reserves beyond the minimum capital requirements) have exploded from around $2 billion in ordinary times to $363 billion as per November 5th. Apparently the banks don’t trust individuals and companies enough to lend them this money. So why not buy government securities then?

It looks like a smart deal: the government finances it growing deficits by borrowing from the troubled banks who in turn can benefit handsomely from the yield differential because the Fed is essentially lending the money to the banks free of charge. Nice side effect would be that the government needs to rely less on the willingness of foreigners to finance its deficits as those foreigners are likely to need their cash to finance their own spending programs.

But isn’t this debt monetization? Isn’t this about the same as if the Fed would directly buy government bonds? Bottom line it is, but it’s slightly more elegant and of course helps to shore up the battered balance sheets of the banks along the way. The questions is though if it will work as debt monetization immediately leads to increased inflation expectations. In order to prevent a new inflation scare from occurring the Fed could introduce an inflation target though, promising to tighten monetary policy if inflation risks take the upper hand. That should keep the money markets silent.

What remains is what would happen to the U.S. dollar in such a scenario. It would probably go down. It might make sense for the banks who have access to Fed funding to lend to the U.S. government at artificially low rates, but foreigners would probably think twice before doing so. This together with the fact that these foreigners will have to spend more of their money at home, will probably put the dollar under pressure. Another interesting characteristic for those who are looking to enter into dollar carry trades.

So who needs the yen any longer? Get ready for the dollar carry trade.