Dollar carry trade + Obama in China = Volatility ahead
Stocks will be volatile next week.
On November 16 through 18 U.S. President Barack Obama will meet with Chinese president Hu Jintao and other Chinese leaders.
The currency markets will study every word and rumor out of those meetings in Beijing for clues on when China will let its currency appreciate, on what China might be thinking about dumping dollars, and on whether the Obama administration intends to do anything to stem the dollar’s decline.
It’s doubtful that currency traders will get anything definitive out of the meeting. But it’s almost certain that they’ll get enough news and rumor—quite probably contradictory from hour to hour—to drive a currency market where every trader is betting big either long or short on the dollar.
And since it’s the U.S. dollar that’s driving stocks—up when the dollar’s down and down when the dollar’s up—equity markets will dance to every change in the dollar/renminbi tune.
I’ve written so frequently about the dollar carry trade that you probably know my explanation for how it is driving stocks higher right now by heart so I’ll keep it brief here: Traders borrow U.S. dollars at very low U.S. interest rates (The Federal Reserve’s short-term interest rate target is 0% to 0.25%) and then use those dollars to buy assets with higher yields (Australian or Brazilian bonds) or with the potential for higher capital gains (commodities, commodity stocks, emerging market stocks.) The result is that this borrowing results in capital inflows that push up the prices of these assets and of the markets where these assets are traded (including the U.S. market).
What I haven’t, perhaps, stressed enough is that as this trade goes on, that is as more and more traders make the same trade of borrowing U.S. dollars and then buying higher returning assets, the trade gets more volatile. The size of the trade and the fact that just about everybody is on the same side of the trade—there are lots of traders selling dollars (by borrowing them) and very few buying them—means that there’s almost no chance that the exit from this trade will be orderly. In fact, most traders with any experience in the currency markets know that there’s a good likelihood that only the first to exit will be able to exit with their skins intact.
As you’d expect, that makes everyone hyper-sensitive about any sign that they should be headed for the exits.
The likelihood as I’ve written about repeatedly is that this trade will go on until the Federal Reserve signals that it is ready to start raising interest rates. Higher U.S. interest rates probably translate into a stronger U.S. dollar and no one now involved in the carry trade wants to have to pay back their cheap loans in more expensive dollars.
With the Fed clearly not positioned to raise interest rates in the first half of 2010, you’d think that “carry-traders” could relax.
Not a chance. The trade is now so big that experienced traders know it’s large and lopsided enough to create its own dynamics. Something much smaller than a Federal Reserve signal of higher rates could send a few traders to the exit. Other traders observing their exit could then follow suit. And before you know it, the exit has fed on itself until you’ve got a panicked rush out the door.
What stops that from happening on any given day is greed. The carry trade is hugely profitable if you operate at the scale where you can get loans at near 0% and if you’re willing to leverage your capital—by using borrowed money, remember—at 5 or 10 or more to one.
Nobody wants to exit this trade until they have to. But nobody wants to be trapped when the exits get clogged with bodies either.
So on every rumor traders, some traders head to the door—creating a dollar rally and sending stocks lower—while others look to see if this tentative move is actually time to exit. And when it’s not, these traders put positions back on or increase their borrowing—sending the dollar lower and stocks higher.
Volatility gets an added boost from the dollar’s very narrow trading range over the last few days. Resistance on the dollar index—that’s the ceiling—is at 75.60. Support—that’s the floor—is 75.20.
This kind of narrow trading range almost always gets resolved by a breakout either higher or lower.
And that historical pattern is just one more thing to make traders nervous.
My best guess is that we won’t see any decided move in one direction or the other in the coming week. There’s just too much chance of a random news headline sending the market into a big unpredictable move up or down for traders to be willing to bet big in one direction or the other.
So look for big moves but no net change next week.
Unless the market manages to scare itself.
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Jim, thanks again for communicating clearly and timely! Keep up the good work.
Hi Jim,
One request – I am sure a great many of us manage our IRAs as well where an ETF of Fund strategy may make more sense. Can you start an ETF corner or provide your ETF inouts (so say when you pick a GG, would a GLD or GDXJ be prudent for IRAs)?
thanks for your consideration.
PS: Didnt know where to make this request…
wow, this is a very good article. Thanks! Yesterday, I happen to sell some high risk stocks that rose too fast and too much in the last 10 days or so. If the market moves down big on one day just because of the words from those 2 big men in China, like you just predicted, I may use those cash to jump in again.
Just signed up for your website today Jim. Your tidy explanation of the carry trade (and especially the implications when it begins to unwind itself) was the best analysis on that topic that I’ve heard so far. I’m hooked!
Jim, so what does this mean for gold. Gold has gone up as the dollar has gone down. Even if it is thought that the dollar may strengthen due to anticipation of higher interest rates or whatever, would you expect gold to drop. Or, do you believe that in the long term the dollar will continue a decline as will other fiat currencies and thus gold is worth holding for the longer term.
Good article, thanks. Aren’t many of these carry trades protected with some form of insurance, CDS’s, derivatives, etc? What happens to these and the counterparties who issued them whe the dollar snaps back?
Do any of these stocks (DRIPs) permit participants to buy additional shares by sending them a cash payment (optional purchases)?
Jim,
For want of a better place to post this. . .
From Bloomberg:
“Baltic Dry
Shipping shares advanced as the Baltic Dry Index, a measure of shipping costs for commodities, posted its biggest weekly climb in a seven-week winning streak. Mitsui O.S.K. Lines Ltd., operator of the world’s largest merchant fleet, rose 1.5 percent in Tokyo and China Cosco Holdings Co., the biggest operator of dry-bulk ships, climbed 2.7 percent in Shanghai.
“
I’m confused…sometimes the currency of China is called the yuan and at other times, it is referred to as the renminbi.
Which one is it, or is it both?