Posts Tagged ‘carry trade’

A Thought on the Dollar Carry Trade…

Why is the stock market not plummeting while the US dollar index gets stronger?

Well, maybe it’s because the dollar carry trade is being replaced by the Yen carry trade?

Since November 30 the Yen rose from 86.28 to 89.86 to the dollar. At the same time, the US dollar index jumped from 74.50 to 77.09.

So the charts confirm my suspicion. It also means that the dollar can move higher without affecting the stock market much.

The move to the Yen is justified since Japan is suffering deflation and will keep interest rates low for a really, really long time. And by this time next year, US rates will probably be higher.

Is 10,500 a no go?

10,500 is like the land the Dow dare not close above.

It didn’t even matter that the unemployment count for November was far better then expected (a 11,000 drop). After starting the day up over 1%, the Dow Jones and the other two indexes both ended the day barely in the green.

The funny thing is that the good economic news actually contributed to the markets rough going. It all has to do with the complex and far reaching implications of an improving labor market and its effect on the dollar.

You see, most currency traders like to see an economy producing jobs. It makes them want to buy more of that currency, pushing the price higher.

The problem is, the dollar is being used to fuel a huge carry trade. If the value of the dollar  increases,  the carry trade becomes more expensive. Eventually any fund that is short dollars (borrowing) will have to unwind its carry trade (close out the loan and take a loss). And the dollar moves up, up, up.

This scenario is pretty much what happened today, albeit on a small scale. The November unemployment report came in strong, and some currency traders took that as a sign of strength for the buck. At the same time, the increase in the dollars value spooked carry traders into closing out their positions.

This drained liquidity from the global markets and resulted in all three major indexes closing at the lows of the day. Frankly, i’m shocked we didn’t close out deeply in the red.

Here’s the kicker…

If the market is weakening over employment numbers, how badly will it weaken once the Fed announces an end to its MBS purchases in the first quarter of 2010? How will the market react if the Fed raises rates by June 2010?Or the passage of FAS 167 in January 2010? All of these things are dollar bullish and should add downside pressure to the stock market throughout the year.

And on a finally note, let me show you a chat of the Dow Jones. It shows the important inflection point we now sit at.

Bailouts, Bailouts Everywhere

Gold has officially broken through $1,200.

All it took was the hope of a bailout of the world’s most extravagant real estate bust – Dubai. Well, not entirely.

Japan also promised it would inject another $114 billion into its economy by offering banks cheap short-term loans. It’s also expanding the type of collateral it receives.

Bailouts are happening all around the world. It’s the new “in” thing to do. Think about it: Nearly every major credit catastrophe has been delayed by a big bailout. Only Iceland and Lehman slipped through the cracks. And now the talking heads use those two stories to convince everybody that a bailout is the best option.

So moving forward I don’t see an end to the bailout bonanza.

You also shouldn’t forget about what money printing means for Japan. It could begin another Yen carry trade. A Yen carry trade plus a Dollar carry trade would allow for a massive bubble to blow. The ending wouldn’t be pretty.

But who knows, maybe the Feds will figure out another way to keep the Ponzi scheme going…

With cheap money pouring into the economy by means of the Yen and Dollar, it’s hard to envision the uptrend breaking. But I still feel that by early next year we could see prices 10-20% lower than they are today.

In the short-term, a break above 10,500 in the Dow Jones would signal more gains ahead. As of right now, though, the Dow isn’t able to settle above that level, which will keep me away from getting into any short-term long positions.

As for gold, I’m not a buyer at these levels. I tend to stay away from any asset that’s gone parabolic (like gold). I loved gold at $1,050. But over $1,200 is hard to swallow, especially with no other significant corrections.

Two Outcomes for the Dollar Carry Trade

Right now the dollar carry trade is fueling the stock market as traders borrow the buck and buy riskier assets (anything else). So when will it all go bust? I’m not sure, i’m not Miss Cleo. But I do see two possible outcomes.

Outcome #1 : Dramatic Fed tightening pushes the buck higher as carry traders sell off their assets and buy back the dollar. In this scenario, markets would plummet viciously.

Outcome #2: The Fed raises rates slower than the rest of the world and the carry trade continues. Eventually, higher interest rates  make the carry trade less profitable and the Japanese Yen, which also has near 0% interest rates, becomes the carry trade of choice. In this scenario, the market keeps moving higher.

What the Feds do depends on inflation expectations. If everyone anticipates higher inflation, the Feds will jack up interest rates quickly. But if  inflation isn’t a concern (the view at the moment) then interest rates won’t move up so quickly.

The economy is running on pointless tax credits and stimulus spending, nothing else. And the U-6 unemployment rate will likely hit 25% by the time this thing bottoms out. So I doubt the Feds will raise rates before the second half of 2010. And if the Feds do raise rates earlier, it just means that inflation expectations had gotten severely out of whack.

That’s why the dollar carry trade will soldier on and keep fueling this market until next year. Sure, we might see a few minor 5% – 10% sell-offs over the next few months. Hell, the Dow may never pass 11,000.  But I doubt we’ll ever see 6,000 on the Dow Jones ever again.

MARKET TREND OUTLOOK

The trend is still up, but the major indexes are all overbought. So we’ll probably see a 3%-5% sell-off.

Use any major sell-offs as entry points unless we see a lower-high, lower-low pattern forming.