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Beware of The Carry Trade

January 30, 2010

One good explanation for the sustained downturn we recently had these past few days is the “bull flag” breakout in the US dollar. During most of 2009 when the market was rallying, the US dollar did not break its 20-day upper bollinger band once until November, and did not make several closes above it until January. The dollar also failed to make a 50-day high the entire rally, including November,  and began threatening this milestone level in late December. Recently it made a decisive breakout. Why does this matter? Because with “free” interest rates, investors were borrowing for next to nothing in US dollars and speculating all over the world in commodities and stocks–including the US stock market. The money has to be returned at some point, and when the dollar is rising people get margin calls. This would account for the failure of the market to snap back as fast as it normally does, as speculators sell their gold, commodities and stocks into weakness to balance their books to avoid getting run over. As we saw in 2008, the dollar tends to rise in periods of weakness, and this becomes a self-perpetuating problem for other asset classes when a trend begins to strengthen. The yield curve is currently very steep, and to correct these imbalances it will need to flatten somewhat and short-term rates will have to give. Again rising rates are also bad for the market. Investors also have to be aware of the great ponzi scheme going on between China and the US, and the possibility of a surprise revaluation of the yuan. Bottom line is, this year has the potential for strange market shocks–and you should adjust your position sizing accordingly: don’t get out on margin, and try to hedge your weak links.

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