A rally with red flags

Fear depresses the carry trade temporarily, but how long until greed takes over?

By Jim J. Jubak Nov 3, 2009 3:00PM

Jim JubakI don’t like the current market or rally much.

Stock prices at current levels aren’t supported by today’s economic fundamentals. Or by tomorrow’s, either, in all likelihood. 

The last leg of this rally has been built almost solely on speculative cash flows, in my opinion. 

Borrowing in the global dollar carry trade -- where traders borrow U.S. dollars at interest rates near 0% and then use that cash to buy commodities, commodity stocks, commodity-backed currencies, and emerging market equities -- has been the biggest source of that cash.

Which is why I don’t think the rally that started on March 9 is over yet. The carry trade has taken a brief leave of absence as the U.S. dollar has bounced from an oversold position. But the fundamental weakness of the U.S. dollar is too strong to deny.

Traders may be nervous -- they’re more optimistic than I am but they don’t really trust the economic foundations of this market either -- but they’re also greedy. 

Tell me why, in the absence of evidence that the Federal Reserve is about to raise interest rates or that the global economy is ready to collapse, traders should abandon a trade that looks guaranteed to net profits for months to come?

I don’t know if the correction -- so far a mini-correction of less than 6% on the Standard & Poor’s 500 stock index -- is over. I suspect not. But I can already see signs that that ol’ devil of a trading game is reasserting itself.

For example, look what happened in Asia’s currency markets the morning after figures showed a pickup manufacturing activity in the United States.

Seven of Asia’s most traded currencies -- aside from the Japanese yen -- climbed against the dollar with South Korea’s won leading the way on predictions of rising exports if the U.S. economy was strengthening.

In Australia, expectations are that the Reserve Bank of Australia will increase its target interest rate to 3.5% from 3.25%. That increase, which would be the second in four weeks, would widen the gap between Australian rates and those in the U.S. and lead to further strength in the Australian dollar and in Australia equities. 

Let’s see: borrow at 0% in the U.S. and invest at 3.5% in Australia. Tell me why you wouldn’t make that trade?

The Australian dollar climbed to just short of 91 cents. Economists and currency traders are predicting that the Australian dollar will hit parity with the U.S. dollar sometime in 2010.

In the last week or so, fear has put a pause to the carry trade and its profits. I can’t see current levels of fear holding greed at bay for very long, however.

And that’s why I think this is just a correction. (For a long-term perspective, see this post).

At the time of this writing, Jim Jubak didn't own or control shares in any company mentioned in this column.



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