Arbitrage is an unfamiliar term. However, our Economy depends on it for every transaction. The simplest explanation is buying cheap in one market and selling higher in another market.
Everyday, you sell your productive work time in exchange for the necessities, and luxuries, of life. You wouldn’t do it unless you believed that your time was of cheaper value – to you – than the things you exchange it for.
If you opened a business, you might buy a product cheaply through a wholesaler and sell it for a higher price at retail. If you borrow money in your business, you would do so only if you believed that you could profit more than the interest due on the loan. If you borrow money at low interest and lend that money to a third person at a higher rate, that’s arbitrage.
In each case, you are attempting to buy value cheaply in one market and sell value expensively in another market.
Though the use of the process is widespread, the familiarity of the term is quite narrow, usually referring to taking advantage of slight differences of price for the same item in different markets. Let’s look at a particular international example.
Interest rates in different countries usually are set – or greatly influenced – by the Central Bank in that country. In the US, the FED controls our country’s interest rate policy. Under Keynesian Money Theory, a lower interest rate would stimulate the Economy by making the cost of money cheaper.
To execute this policy, the Central Bank would create, using its “printing press or electronic equivalent,” new paper currency. In the US, the FED prints new Dollar bills to be lent through the banks. An expanded supply of the paper money induces the banks to charge a lower rate on loans.
Central Bank manipulation of interest rates lower causes more paper money to be in the Economy. This increased money supply bids to buy all the goods and services available in the Economy, and the result is a general rise in prices so long as the money creation continues. To Free Market economists like myself, this practice is despicable, but policy makers don’t ask for my advice.
The interest rate policy will be different in different countries – higher rates in one country vs lower rates in another country. This opens up an opportunity for arbitrage. If you could borrow in the low interest rate country and lend in the high rate country, you could earn the spread between the rates.
Let’s say you borrow in Dollars, exchange these Dollars for Euros on the Forex markets, and then buy a bond in the Eurozone. This is referred to as a Carry Trade.
Since the spread usually is quite narrow, you’d want to consider factors which could affect the trade. One factor is the expected change in the exchange rate. When it comes time to end the trade, you’ll have to sell Euros to buy Dollars to pay back your loan. If the Dollar is more expensive – if the foreign exchange rate between the Dollar and the Euro goes up – it will cost more Euros, and you’ll lose part of your profit, or even lose money on the whole trade.
A year ago, the US FED started saying it would end Quantitative Easing (QE). In effect, it said it will slow down its printing presses, allowing rates to rise somewhat, making Dollars more desirable to hold.
Also last year, the European Central Bank started saying that the Eurozone Economy was too slow and that the ECB would consider further stimulus, including its own version of Quantitative Easing. In effect, the ECB was saying it was about to rev up its printing presses to lower rates, making the Euro less desirable to hold.
If you had borrowed Dollars to buy Euro bonds at a higher rate, these policy announcements would have been a warning sign. The FED and the ECB were telling you they were about to change policy, making the Dollar more expensive vs the Euro. You would have started to unwind your Carry Trade if you were paying attention.
The FED has indeed stopped QE, although they have kept interest rates low, and the ECB has indeed embarked on QE over there. The result is that the Euro has gone from $0.72 to $0.88 during the last 8 months or around 33% on an annual rate.
Eight months ago, you could have been the first arbitrageur to close out your trade, so you would not have suffered from the soon to change exchange rate. But, as you and all the other Carry Traders sold Euros to buy Dollars to close out your positions, all of those trades would have pushed the Dollar higher and higher.
The Carry Trade is popular not only with well heeled investors. Central Banks also get into it without realizing it. The Swiss National Bank (SNB) tried to keep the Franc low vs the Euro because Swiss exporters wanted to remain competitive. To maintain the “Peg” vs the Euro, the SNB was forced to buy well over 730 Billion Euros! When they finally threw in the towel and let the Swissie float, they wound up losing 15% in a single day as the Euro fell. That’s over 100 Billion Euros lost!
The surge in the Dollar vs the Euro will be a drag on the US Economy as foreign price competition, both for imports and exports, becomes harder. US company profits will fall, putting pressure on already high US stock prices. And, as foreign profits of US multinational companies will look much lower in Dollar terms, this also is a big negative for stock prices. I expect stock prices to be much lower a year from now.
The FED likely will step on the stimulus pedal once again before long. The Carry Trade of borrowing Dollars to invest in Euros will end and possibly start in the opposite direction.
The Dollar will continue to get stronger until… it doesn’t. The US FED will once again work to cheapen the Dollar by printing more. Then other countries will do the same, in a continuing and sickening cycle of competitive devaluations. All currencies will run a ratcheting race to the bottom resulting in continuing price increases for all the things we need to live.
I don’t dabble in the interest rate and currency markets. Instead, I seek to protect my family with Gold & Silver, which can’t be printed. You might want to look into these Precious Metals, especially bullion coins like the US Silver Liberty Eagle $1 Coin (current price is around $20+ for this 1oz coin).