Beware A Vicious Dollar Rally (Where The Wild Things Are)
By John Mauldin
Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.
For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.
It Is Not Just Japan
Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.
Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can't make money in this environment, you need to quit and find meaningful employment.
And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.
But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.
The Euro-Yen Cross and the Dollar Carry Trade
I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.
A currency 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.
The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.
But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.
We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4th quarter 2009 estimates so as to not have to take into account the disastrous 4th quarter of last year.)
Nov 24, 2009 at 6:03 PM
Reader Comments (8)
If on the other hand you're a bankster and DO "make money" in this 'environment', then you should ALSO quit because basically you're contributing to completely debase and devalue your national currency into worthlessness thru massive issuance of currency and unendingly increasing credit limits that include bailing-out corrupt, mis-managing and inept like yourself.
Actually you all should have quit as a bankster a long time ago ..the moment you FAILED your institution by putting it in the situation it's currently in. Which is why I support a law that would allow US citizens to shoot those banksters that refuse to voluntarily commit suicide after being convicted of fraud.
""But now, there are some who are beginning to ask whether there is a dollar carry trade. ""
Sure, and there are some who are beginning to ask whether the laws of gravity work at night. They're known as 'MORONS'. Everyone else & their cousin has known for QUITE SOME TIME ALREADY that the U.S. dollar is in a heavy carry trade. WTF is wrong with mainstream American economists & commentators lately? They're habitually MONTHS behind in their assessments, when not completely WRONG altogether. Too much graph analysis in lieu of actually looking ahead thru the fucking windshield every now & then in order to see where you're going will do that to people.
And that alleged "vicious dollar rally" (aka "DeadCat Bounce")? Should it occur it'll result as short-lived and empty as Barack Hussein Obama's campaign promises. An excellent opportunity to buy more gold and nothing else.
Obama, you are an ass.
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RR, don't forget silver, if all else fails, a loaf of bread could be expensive if all you have is gold.
DB, you ought to print your own money, your script might be worth more than their script. LOL...