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.