The Carry Trade and Fed Swap Lines

At the end of June, the Federal Reserve extended its dollar swap lines to the European Central Bank, the Bank of England, the Swiss National Bank and the Bank of Canada. During the panic, up to fourteen central banks were using these lines. Simply put: the dollar is the world’s reserve currency and so the Fed is the world’s lender of last resort.

The panic is over now. So what about the carry trade then? Since interest rates are as low as they can go in the US, it makes sense for institutions, domestic and foreign, to load up on USD debt and buy investments wherever the return is highest.

The swap lines were set up to deal with the lack of dollar liquidity that foreign banks like UBS or Royal Bank of Scotland have had. They borrowed dollars short-term in the interbank market, making them subject to rollover risk in a foreign currency from lending long and borrowing short in USD.

Higher interest rates would end the appeal of the carry trade. I am sceptical that the Fed will raise rates anytime soon. You would need a lot more inflation for that to happen. You do have The St. Louis Fed’s James Bullard of “Seven Faces of The Peril” fame out trying to anchor the discussion around headline inflation. However, the consensus at the Fed is going with core inflation — and right now core inflation is not going into the stratosphere. The same is true for the UK by the way, where inflation is well above the central bank’s target. Note that despite Chinese hikes, Chinese real rates are negative, so it’s clear that the Fed and the BoE are not the only ones on easy street.

If inflation does rise it will probably be because of demand-destroying commodity price inflation and bubblicious asset prices. The key thing to watch that could force the Fed’s hand is owner’s equivalent rent. If that rises too much, you would see a reaction by the Fed as it is a sizable percentage of the core.

Bottom line: the Fed is stuck at permanent zero and that means the carry trade is on. If we did have another panic, those swap lines would be handy because the Fed would again become the global lender of last resort.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.