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U.S. Dollar Carry Trade

When Bad News is Good News

Written by Steve Christ
Posted November 19, 2009 at 8:06PM

For the logically inclined, the action in the stock markets these days must be a riddle, wrapped in a mystery, inside an enigma.

That's how backwards things must appear as the unemployment rate goes higher and the markets jump right along with it. It makes no logical sense.

In fact if you compared the rise in the unemployment rate with the rise in the DOW. . . you would be hard-pressed to either explain it or believe it.

Yet as Rick Santelli pointed out last week, the correlation between the two is nearly 1:1. Amazingly, even as the unemployment rate hit 10.2% earlier this month, the Dow closed above 10,200. The strange part: the same thing also happened at 8% and 9% unemployment.

And while this seems like nothing more than an odd coincidence. . . you have to admit it is something of a head-scratcher.

But you don't exactly need to be Winston Churchill to figure out what the game is here. The thread of logic in this case is simpler than it appears: Bad news, as it turns out, is good for the market.

With a constant stream of bad news washing ashore, the Fed won't even begin to think of raising rates anytime soon. In fact, the worse the waters become, the longer it will take Ben Bernanke & Co. to act.

You see, as bizarre as it may sound, the market is actually rooting for bad news to extend the Fed's zero interest rate policy (ZIRP). And if it manages to send the dollar even lower — that's something of an added bonus.

That is the twisted logic the U.S. dollar carry trade has now given us. Because when it costs you virtually nothing to borrow in dollars, you can plough them into other assets in a game with little risk.

The U.S. Dollar Carry Trade Explained

That's why the trade of the moment is still: short the dollar and long everything else.

All of which should work like a charm for Wall Street. Until the Fed decides to change its bias and raise the cost of money, it's game on.

You see, the carry trade is a strategy that enables investors to sell a currency with a low interest rate to buy a different currency yielding higher interest rates. In doing so, they automatically bank a profit by nothing more than earning the spread between the two.

I'll give you an example. In today's world, you could borrow one million dollars at very low interest rate (say 1%), featuring a carrying cost of just $10,000. You could then decide to invest that capital into an asset class with a higher yield (say 5%), earning yourself a quick $50,000. As a result of the interest rate spread between the two, you would earn a tidy $40,000 without moving a muscle.

What's more: If you pulled the same deal at 10 to 1 leverage, you could earn $400,000 for your troubles.

And the best part is that the lower the value of the dollar goes, the more you stand to make.

It's this wager — known as the dollar carry trade — that is undoubtedly one of the reasons the dollar continues to fall.

However, since the Fed has absolutely no control over where all of this liquidity will slosh, it usually flows into new asset bubbles. . . Which is why every other asset class has risen as the greenback takes a dive.

That's how we end up with charts like the one below; the DOW is inversely correlated to the U.S. Dollar (UUP) on nearly every single move. Take a look:

 

dollar carry trade

I don't mean to beat a dead horse here. But there is a method to this madness, as we have been pointing out for some time now.

The Risks to the Dollar Carry Trade

However, while the dollar carry trade seems like something you would find in a market Utopia, these wagers are as risky as it gets — especially when there is leverage involved.

The risk, naturally, is that the logic behind the entire trade will collapse once the dollar begins to rally.

When that change occurs, a market collapse won't be far behind. In fact, it will all happen very rapidly as everyone heads for the exits at exactly the same time.

Which is exactly what Nouriel Roubini correctly pointed out last month when he said, "There is eventually going to be an unraveling of this carry trade, When the snapback of the dollar occurs, it is not going to be 2% or 3%, it's going to be more like 15-20%. Then, everybody would be left to close their shorts on the dollar. You will have to sell these risky assets across the world and then you could have a huge asset bubble going into an asset bust. The crash will be as big as this bubble builds up to."

Of course, where it stops. . . nobody knows. Even Roubini admits the dollar carry trade could on for some time before the Fed decides to act. After all, creating asset bubbles is the one thing the Fed is actually quite good at.

In a way, it's the Fed's specialty. Think of it as lather, rinse, repeat.

The problem is that the current side show bears very little resemblance to what is actually going on all around us.

That's because our collective magic hat is fresh out of rabbits this time — something that wasn't the case in past downturns.

For instance, when you look back at previous recessions, the way out them was pretty evident at the time. There were tax cuts and falling interest rates in the 80s. The 90s gave us the tech revolution, while in 2000 there was room to expand housing.

Conversely, in today's world the answers to our troubles are nowhere in the picture.

Housing is falling. . . Interest rates have nowhere to go but up. . . Higher taxes are a given. . . and there is no brewing innovation with the same power that tech had to lift us out of our doldrums.

All that is left is a Keynesian policy response that cannot go on indefinitely. . .

What's worse, Americans have more than triple the debt they had in 1982 and less than half the savings. On top of that, a bigger share of them has no home equity, leaving them one pink slip away from financial ruin.

These are tough balls to juggle in an economy that relies on consumers for 70% of the total spend. These are the cold, hard realties that the government just can't fix.

But don't tell that to the market. . . bad news is exactly what it's looking for these days.

The only mystery left is how long this show can go on.

In the meantime, every investor willing to ride this wave should be looking at silver as a way to play the falling dollar. After all, as the carry trade drives the dollar lower, silver — just like gold — has nowhere to go but up.

And according to Hard Money Millionaire Editor Luke Burgess, investment in silver more than doubled last year — up 103%.

Luke has uncovered a new silver investment that he believes could return an instant 33% in the short-term and more than double over the next 18-24 months. You can read more about Luke's latest winner here.

In the meantime, don't think for a minute that the Fed will do anything to defend the dollar anytime soon.

After all, stupid is as stupid does.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory


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