Many analysts have speculated for months that a sharp rally in the U.S. dollar could create a quick and dramatic sell-off in equities around the world (as well as in the U.S.), as global currency speculators move to close out short-term debt positions in the U.S. As a result of last year’s financial market meltdown, the U.S. government took extreme measures to stabilize the economy and stave off economic disaster. One of these measures included keeping short-term interest rate targets at historically low levels–well below one percent. Concomitantly, worries about the U.S.’s exploding debt levels caused the dollar to sink throughout a good portion of 2009. This made the U.S. debt market one of the cheapest sources of funds for global speculators who wish to use the “carry trade” to their advantage. The “carry” in carry trade refers to the cost of holding an asset. When it is positive, this is known as “return” and return is what all investors are looking for in an investment. A negative carry is cost and is obviously something most would seek to avoid.
By definition, the whole concept of “carry trade”, as it has come to be known, entails the heavy use of leverage. Ideally, speculators seek to borrow money from a nation whose short-term interest rates are comparatively low and whose currency is in decline relative to others. The speculator can then re-invest that borrowed money in whatever asset class offers the best prospect for appreciation. When U.S. equities hit their nadir in early March, there is no doubt that speculators saw opportunity and began channeling money into U.S. (as well as foreign) stocks. It is logical to assume that a good portion of that inflow was borrowed money from investors using the carry trade.
However, leverage removes patience from the investment equation. Investors who purchase securities without the use of leverage can weather down markets far better than those who borrow to buy. Add the volatility and unpredictability of currency movements into the equation and you have a recipe for one hell of a wild ride.
While many commentators predicted that there would eventually be a rally in the dollar—even if it were nothing more than a “dead cat bounce”—that rally, which began in mid-November, intensified this week. On Tuesday, there was a much-publicized Senate race in Massachusetts in which the Republican, Scott Brown, defeated Democrat Martha Coakley to complete the term of the late Senator Ted Kennedy. This stunning upset was considered a repudiation of some of the largest pieces of legislation pending in Congress (health care reform, “cap and trade”, financial regulatory reform, etc.) Some market commentators (Jim Cramer comes to mind) even went so far as to predict that a Brown victory would spark a strong stock market rally. Indeed, on Tuesday, there was a strong rally in equities, but it was short-lived. The theory undergirding such prognostications was that this election signaled a return to divided government, and would force a move the center by the Obama administration and perhaps demand a greater focus on spending restraint throughout our government. This should normally be good news for stocks.
It would appear to us that these conclusions may also have been reached by currency traders and those who utilize the carry trade to find alpha. For much of the last year, the dollar declined as our spending went through the roof and legislation being crafted promised to further balloon U.S. deficits in the years ahead. Countless articles were written predicting an eventual U.S. credit downgrade or even default. Yet now that concerns about runaway government spending have risen to the forefront of the national political debate with Scott Brown’s win, it appears that the dollar is finding some fans around the world again. This is only logical since, despite our enormous problems, the economies of the EU, Japan, China and developing nations all face significant issues which in many cases are greater than our own.
Stock selling volume accelerated yesterday and U.S. Treasury debt reversed its recent decline. This coupled with an accelerating dollar rally leads us to conclude that the sudden end of complacency and even a whiff of fear in the U.S. equity market may be as much a result of an unwinding global carry trade as anything. The volatility indicator or VIX has risen quickly recently, and is on pace for 32% rise just this week. Clearly, earnings season has not provided the kind of disappointment that would account for this recent sell-off. The President’s proposed attack on big banks, while certainly a negative for this crucial (and still wounded) sector of our economy, seems to have little chance of becoming law post-Scott Brown.
If carry trade speculators are indeed unwinding their positions, then the equity sell off could be deeper than fundamentals might warrant. We have said for some time that equities were not cheap and advised caution on adding new positions. However, we did not—and still do not—foresee a major pullback. However, an unwind of the carry trade could intensify and prolong any pull-back. Thus, equity investors may want to be especially cautious at the present time.