As the U.S. Dollar Index makes new lows, equities make new highs and the momentum continues. Where is the ‘juice’ coming from? Is this cash that had previously exited the market now reentering? Is this people who had gone short now being forced to cover? Is this ‘new’ money finding value? Is this a pickup in short term day trading? The answer to all of these questions is yes, albeit to varying degrees. However, the most widely held belief for the rally in the market is the dollar ‘carry trade.’
I highlighted this trade last week in my September 12: Month to Date Review of the Markets. On that day, I wrote about the U.S. dollar:
Commentary: The decline in the value of the U.S. greenback by approximately 2% reminds me of the overused Wall Street phrase, ’squeal like a pig…’
The fact is Big Ben Bernanke is not only funding the domestic economy with the Fed Funds rate at 0-.25%, he is also funding the spike in a number of markets around the world. How so? Investors around the world have entered and, given this week’s price action, continue to enter into the ‘positive carry‘ trade in which they borrow U.S. dollars to purchase higher risk assets.
This ‘positive carry’ trade was fed by the Japanese yen throughout the ’90s given the exceptionally low rates in that country.
Make no mistake, though, this ‘positive carry’ trade is nothing more than implementing leverage. Do not confuse leverage with brains when a market is rising because as I said the other day, leverage is death when that bull becomes a bear. As I think of market developments, I am convinced that this ultimate unwind of leverage trades currently being implemented is Jeff Gundlach’s reasoning for being bullish on the dollar. How will this work? Investors will look to exit their risk based investments (emerging market stocks and the like) and buy back the dollars which they have borrowed. In the process, the dollar may rally significantly. The timing of this unwind is the critical question.
This morning, the Financial Times weighs in with Dollar Lays Claim to Being Top Carry Trade Currency:
For years, the yen was the currency of choice to fund international carry trades. But is the dollar starting to take its place?
Analysts say negligible US interest rates, its quantitative easing measures and little sign that the country is set to withdraw from its ultra-loose monetary policy anytime soon leaves it in a similar position to Japan at the start of the decade.
“This puts the dollar in exactly the same position as the yen back in 2001 and makes it naturally attractive as a carry trade funding currency,” says Simon Derrick at Bank of New York Mellon. “The dollar is the new yen.”
The carry trade strategy, in which low-yielding currencies are sold to finance the purchase of riskier, higher-yielding assets, was widely used in the years prior to the eruption of the financial crisis.
The FT further adds,
Speculative positioning data seem to back up the shift against the dollar, revealing the extent of recent deterioration in dollar sentiment.
According to figures from the Chicago Mercantile Exchange, which are often used as a proxy for hedge fund activity, aggregate bets against the dollar versus the euro, yen, Swiss franc, sterling and the Australian, New Zealand and Canadian dollars last week rose to their highest levels since July 2008, when the dollar hit a record low against the euro.
Is utilizing the dollar for funding purposes a harmless risk-free trade? Anything but. A weak dollar impacts all dollar-denominated assets and dollar-denominated transactions.
For those entering into these transactions, a sharp reversal in the dollar or in the assets being purchased can lead to tremendous losses. For now, though, traders, hedge funds, and speculators the world over are selling dollars to put this dollar carry trade on . . . in size!
What do our ‘wizards in Washington’ have to say about the plummeting dollar? You can hear a pin drop.