IMF Says Dollar Funding ‘Carry Trade,’ May Be Still Overvalued

Nov. 8 (Bloomberg) -- The International Monetary Fund said traders are probably using the dollar to fund “carry trades” around the world and the currency may still be overvalued even after its slide this year.

“There are indications that the U.S. dollar is now serving as the funding currency for carry trades,” the IMF said in a report published yesterday. “These trades may be contributing to upward pressure on the euro and some emerging-economy currencies.” While the dollar “has moved closer to medium-run equilibrium,” it is still “on the strong side.”

With investors able to borrow at near-zero interest rates in the U.S., some economists are concerned that markets may become distorted as traders plow those funds into riskier assets. Nouriel Roubini, the economist who forecast the financial crisis in 2006, said Nov. 4 that investors are milking the “mother of all carry trades.”

“U.S. interest rates look to remain near zero through the first half of 2010 at the very least, which provides traders plenty of time to continue with carry trades,” said Boris Schlossberg, director of currency research at the online currency trader GFT Forex in New York. “Labor-market conditions are still very challenging in the U.S., and the rest of the world is improving faster. The dollar remains the weakest link.”

Dollar’s Slide

The dollar has dropped about 13 percent against a basket of currencies from its major trading partners in the past seven months. Meanwhile, the MSCI All-Countries World Index of global equities has gained about two-thirds since March and sugar has soared 90 percent this year.

U.S. Federal Reserve policymakers, at the end of a two-day policy meeting on Nov. 4, reiterated their intention to keep interest rates “exceptionally low” for “an extended period.”

Speculation that the Fed will keep rates on hold into next year was further fueled by U.S. Labor Department figures on Nov. 6 that showed the nation’s unemployment rate jumped to 10.2 percent in October, exceeding 10 percent for the first time since 1983.

In a carry trade, investors borrow in countries with low interest rates to invest in higher-yielding assets. Benchmark interest rates of 0.1 percent in Japan and as low as zero in the U.S. compare with 7 percent in South Africa and 2.5 percent in New Zealand, making the yen and dollar favored targets for investors seeking to fund carry trades.

Marc Chandler, global head of currency strategy for Brown Brothers Harriman & Co. in New York, said the dollar carry trade is likely to continue in coming months, and he expects the U.S. currency will decline further.

Risk Appetite

“The key wildcard to dollar carry trades is whether people continue to show an appetite for risk,” Chandler said. “That’ll weigh on the dollar.”

The euro’s exchange rate “is on the strong side of its equilibrium,” the Washington-based IMF said.

The fund, which published the report as officials from the Group of 20 nations gathered in St. Andrews, Scotland, also said that China’s yuan is “significantly undervalued.”

The Chinese currency “has depreciated in real effective terms in tandem with the U.S. dollar and remains significantly undervalued from a medium-term perspective,” the IMF said.

China has kept the exchange rate at about 6.83 to the dollar since July 2008, after letting the currency strengthen 21 percent in the previous three years. Appreciation was halted to help sustain exports amid a global recession.

Chinese central bank Governor Zhou Xiaochuan told Bloomberg News on Nov. 6 that “the pressure from the international community to allow yuan appreciation is not that big,” deflecting calls from Europe and Japan to let it rise.

Since President Barack Obama took office this year, “the U.S. hasn’t been as vocal” about the Chinese currency as it was previously, Brown Brothers’ Chandler said.