Check Out These Charts

The charts below are charts of the US Dollar and the S&P 500. When you compare the first chart, the daily chart of the US Dollar (as tracked by DXY, the US Dollar Index Future) with the chart of the S&P 500, they look like mirror images of each other don’t they?

Why is that?

I discuss some of the possible reasons in my December issue of “Moving Markets” which is available free by clicking here: www.usawealthmanagement.com.

I have printed an excerpt on this topic below.

Can the stock market recovery be directly linked to the decline of the dollar? Or, has the stock market rise since the March lows been a result of real economic recovery and better prospects for business and earnings?

While this is a complex issue, let’s explore one possible explanation – something called a carry trade. A carry trade is a trade that an investor might make by borrowing or buying US Dollars cheaply and then investing in other higher yielding assets denominated in other currencies.

To be sure you’re clear on the concept; here is the definition of a carry trade and an example from Investopedia, a Forbes Company:

“A carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

Here’s an example of a “yen carry trade”: a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then he/she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately”

A yen carry trade as described in the example was a common trade during the early part of this decade. The Japanese Central Bank set interest rates at zero to stimulate its economy (sound familiar?). At the same time, hypothetically speaking, let’s say an investor could buy US Treasuries and earn an interest rate of 4.5%. The investor could earn a ‘spread’ or profit of 4.5% with another potential plus. If the US Dollar rose in value against the Japanese Yen, the investor would have two profit sources. Profit source one is from the spread earned on the transaction and profit source two from the exchange rate; as the Dollar rose against the Yen, the investment would appreciate since, when converting the Dollars back to Yen the investor would receive ‘more Yen’ than was originally invested.

As you can see, this carry trade is profitable for an investor as long as there is enough ‘spread’ in the interest rate and as long as the currency in which the investor invested continues to rise against the borrowed currency. However, in the example above, if interest rates in Japan rise or the US Dollar loses value against the Yen, the investor could lose money. Losses can mount especially quickly when an excessive amount of leverage is used.

In today’s environment, the US Dollar may have become the Yen of the latter part of this decade. In an effort to spur economic growth, the Central Bank of the United States has deemed it necessary to keep interest rates at zero. This has made it possible for many investors to borrow US Dollars at zero interest and invest in other currencies where yields are higher. Of course the more investors borrow, the greater the potential investment loss when interest or currency rates change.

It’s widely accepted that this US Dollar carry trade has been taking place on a large scale, although it’s difficult to know exactly how large. This from a CNN Money article published September 22, 2009:

“Critics focus on the fact that low U.S. interest rates enable investors around the globe to borrow dollars for next to nothing and invest them elsewhere at higher rates.

This bet — known as the dollar carry trade — appears to be one of the forces pushing down the value of the dollar. Though there are few reliable figures on the size of the carry trade, the dollar’s trend has clearly been down since stock and bond markets revived.

The buck recently traded at its lowest level against the euro in a year, while the trade-weighted dollar index has dropped 14% since March.

The resulting investment flows are potentially unstable, prompting talk of new asset price bubbles — particularly in commodities such as oil and gold, and the economies of faster-growing emerging markets.

That sounds like an unpleasant arrangement, but Americans may have to get used to it. The Fed, which is expected to hold interest rates steady when it wraps up a two-day meeting Wednesday, has said it anticipates keeping its fed funds rate near zero for an extended period.

That could mean months of a currency-depressing, growth-stunting carry trade — an echo of Japan’s experience during two decades of on-again, off-again zero interest rates.”

The CNN Money article mentions the possibility of asset bubbles occurring in oil, gold and potentially even emerging markets where economies are faster growing than the US economy. This, arguably, has occurred.

Since the September article was published, already high gold prices have spiked by another 20% or so. And, the International Monetary Fund is concerned the US Dollar carry trade has indeed begun to cause bubbles around the world. This from an article published on November 9, 2009 in “The Business Insider” (highlighting mine):

The International Monetary Fund (IMF) highlighted the fact that low interest rates in the U.S., plus an apparent “one-way” bet against the dollar has created a global dollar carry-trade that is driving capital flows into emerging markets

If not handled properly, this will lead to emerging market asset bubbles, which arguably have already begun to inflate.

We’ve highlighted before how places like Hong Kong are seeing property prices go through the roof due to low U.S. interest rates.

The fact that the IMF is increasingly vocal on the subject suggests that this process is really starting to become quite a substantial phenomenon in many countries.

IMF: There are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the euro and some emerging economy currencies. Emerging economy authorities have been responding to capital inflows by accumulating reserves, and, in some cases, with capital controls and other measures, to slow the pace of appreciation. Capital flows driven by yield differentials are complicating monetary policy responses in those economies where there may be a need to tighten—particularly in Asia.

Some emerging economies may need to absorb capital inflows and at the same time avoid compromising domestic financial and price stability. With interest rates in advanced economies set to remain low for an extended period, and emerging economies poised to recover at a faster pace, the recent flow of capital into these economies may continue.

So the question is simply this: Is the recent stock market rally a result of an improving business climate or simply a result of low interest rates and a weak dollar?

While we won’t know for sure until some time passes, we’re inclined to believe the latter given some of the evidence.

Securities offered through USA Advanced Planners (Member FINRA/SIPC). Advisory services offered through USA Wealth Management. USA Advanced Planners and USA Wealth Management are affiliated companies. The opinions expressed herein are those of the writer and not necessarily that of the above noted affiliated companies. This update may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. The information obtained from third party resources is believed to be reliable but the accuracy cannot be guaranteed.

This information is education in nature and, therefore, is not intended to constitute investment advice and should not be interpreted as a recommendation to purchase, sell or hold a particular security. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal situation of each individual investor. Investing in market related securities involves a risk of principal loss