Trader’s Narrative

What 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.

For economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all, go to news.tradersnarrative.com:

• Bill Moyers interviews James K. Galbraith
• Market Is Strong, But Correction Should Continue
• Contrarian analysis remains bullish
• Goldman’s long term borrowing cost 0.92%
• Get a FREE Subscription to SFO Magazine (US residents only)
• EU to break up Lloyds, RBS and Northern Rock
• Schwab Creates Watershed Event with Commission-Free ETFs
• CNN Interviews Robert Shiller on Economic Recovery
• EWI FreeWeek almost over, hurry! Learn more about FreeWeek, and download your free reports here
• Mother of all carry trades faces an inevitable bust
• Four Simple Ways to Fix the Broken System
• Clever fools: Why a high IQ doesn’t mean you’re smart

The above is a small sample, for the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back during the week as there are interesting links added throughout the week. If you are a twitter user, add the news.tradersnarrative.com twitter stream to get new stories in real time.

The Week Ahead:

No question, this was a financial shock that leaves everyone grasping for superlatives. But as measured by the TED spread and other financial health metrics, it is all but over:

Unlike the CBOE VIX volatility index which reached record territory, this spread has been higher actually. I’ll scrounge up a very long term chart. But the important thing is that the TED spread has now come down so much that even if it blips up, it has put in a lower low. So while we may see an uptick or two since nothing every goes up or down in a straight line, the chart suggests that things have calmed down.

But what the shock has resulted in is just getting underway. A complete re-ordering of the financial landscape: RIP the carry trade. Now watch as the currency markets drive the equity markets. They are after all a zillion times larger.

Can you tell which chart is the S&P 500 and which the Euro Yen cross?

A dozen spoos points and a slightly singed Swingline stapler to the first lucky guesser.