Dollar carry trade, and bonds

13/11/2009 by Philinje.

The dollar bounced then came right back down to 75 and bounced back up to 75.7. Gold got to a hew high at $1123 or so and came right back down to $1100 as the dollar bounced up again. What a see-saw.

The sentiment in forex markets is negative on the dollar because last Friday the Non-farm Payrolls report pretty much sealed the deal that the Fed would not raise interest rates, at least until Jan. That’s what caused the dollar to come right back down to 75 (actually a little under). But at this point that level looks like a double bottom, and who knows, there may be a decent rally in the works.

There is a hidden risk lurking behind the current reflation, and that is the newfound popularity of the dollar in carry trades. Everything seems to be counter-correlated to the dollar right now. Dollar goes up, markets go down. Dollar goes down, markets go up.

The reason is apparently because of the super-low interest rate on the dollar, currently at 0.25%. That is lower than the Euro, GBP, AUD, etc. and about on par with the Yen. This means that it has become popular for traders to borrow dollars to purchase other assets or other currencies - at least until things turn.

And that’s the risk. If there is any kind of scare from bad news, all those “short” dollars will be un-borrowed in a hurry. Last October that is what caused the Yen to spike so dramatically. The dollar spiked also, partly because so many obligations or assets are denominated in dollars (and were reversed in a hurry) and partly because it is a safe haven. Now, the dollar is competing with the Yen as the carry trade currency of choice.

This is why some notable commentators have declared a rally in the dollar in the near term. Here is an example from Nouriel Roubini:

http://www.nakedcapitalism.com/2009/11/roubini-predicts-mother-of-all-carry-trade-unwinds.html

Note that he makes the point that so many financial assets and commodities are being fueled by borrowed dollars. It’s clear that with gold, its recent move higher is following directly from dollar weakness. But you could say the same thing about oil and equities. Because it is so easy to make a big profit with money that is less than free, this is the best game in town in the trading world. “Less than free” refers to the fact that paying next to nothing to borrow dollars and parking it elsewhere gives you an excellent rate of return - it’s like being paid to borrow money.

That is, until things turn. Keep in mind that greed characteristically leads to large leverage, which means with a certain amount of collateral people will borrow 2x, 3x, 4x… 100x the amount in dollars to play the same game. When de-leveraging occurred last October, look what happened to the dollar. What happens now when the leverage with the dollar is X times larger?

Forex traders are watching the Euro and dollar to see if the dollar strengthens or the Euro weakens to a point where carry trades would unwind. That would be just above 80 in the dollar index. On Eur/JPY that level might be 120, maybe lower. But on the whole, people expect the dollar to continue moving down because there is no expectation at present the Fed will raise interest rates.

At least one analyst is predicting a small bounce in the dollar to 82 or so. That could be a test of how stable the current house of cards is.

Regarding gold, we may be at a turning point now, or dollar wekaness will prevail and we might get a blow-off top in gold. One target was $1120, another is $1350. If the dollar bounces with some gusto, we could see gold at $1000, and then maybe the blow-off top happens. Or dollar shorts could cover explosively and gold could get hammered down to $960 or lower. Still, in any calamity, gold will do comparatively well. But a 40% hit is still painful, if last October repeats itself.

Another thing to watch is bonds. 30-year US Treasuries seem fairly strong, and it seems they could get stronger. But if they break below 112, look out below. That would add fuel to a dollar rally and then we get potentially explosive de-leveraging in the dollar. If there is a market crash at the same time, whoa.

So, that is why my mood is cautious. Maybe the recovery really is working, or maybe the finance industry is gorging on free dollars. If the latter, then the current picture is quite fragile indeed.

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