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Dollar Carry Trade Correlates All Risky Assets




burning US dollar.pngWhat better way to reliquify the world financial markets than sacrificing a currency?

If you'll recall this is a well worn script. The last time we had a financial crisis, it was the Yen that was used as the vehicle of choice. Massive amounts of capital were borrowed in Yen and invested in other risky assets with the nudge-wink agreement of central banks that it was a one way trade.

Today it is the US dollar that is being sacrificed at the altar of the new bull market... in everything. Roubini has been among the most vocal to raise the alarm. But almost everyone else has decided to enjoy the trade while it lasts.

Of course, the sensible thing is to realize that you can't drink yourself sober, just as you can't dig yourself out of a hole. But since when have monetary policy wonks been fans of reality?

While it is difficult to prove definitively that the US dollar carry trade is the reason almost every single asset class has appreciated, its footprints are hard to miss. Here are David Rosenberg's recent observations on the correlations across asset classes:

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April.

There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring.

Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The scary consequence of the US dollar carry trade is that it has pushed almost all risky assets to be correlated. And when the music stops and someone starts to unwind the trade, it will get ugly. When everything you hold is correlated to each other and everything else in the market, even a small tremor of selling will lead to an avalanche as the value of your portfolio starts to decline all at once.

If you expect gold to be a safe haven, you'll be sorely disappointed. Historically, gold and gold stocks have never been a stronghold in a severe sell off. So maybe that's why short term T-Bill rates have been pushed so low.

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3 Responses to “Dollar Carry Trade Correlates All Risky Assets”  

  1. 1 jerome

    Dollar carry trsde unwind, negative short T Bond interest rates, % from 200 day moving average, Prechters deflationary slump..how many way are you going to come up with to scare us out of this bull market?

    I'm sure that a correction is coming, but where is your long term perspective?

  2. 2 Babak

    jerome, that's an interesting take and I dare say it reveals more about your state of mind than my intentions since I'm not trying to 'scare' anyone out of anything. I'm simply writing about what I see happening in the markets. I was arguing months ago that we'd see a significant rally and showing the Coppock guide and other indicators to back it up. Things are fluid though and you can't get locked into a mindset or position.

  3. 3 John

    I'm wondering where to plot a correlation of the U.S. Dollar and the VIX. Any ideas? As mentioned in the article, their charts resemble each other recently.

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