Carry Trade Gets Clobbered

Charts: The S&P 500 closed at 1091, down a stinging 1.5%. Volume is always low on a holiday week but there is a big technical problem with the recent drop in volume. Low volume exaggerates price moves and makes chart patterns less meaningful. Low volume is a sign that the big boys are not participating in the rally. The uptrend is under severe pressure.

Fundamentals: The government of Dubai is allowing its state owned investment company, Dubai World, to halt payments on $20 billion dollars worth of debt. Dubai World has another $40 billion in debt that is now at some risk of default, big enough to roil the world’s financial markets. After a long hiatus we are experiencing another “shoe” dropping in the credit crunch. Dubai is a Persian Gulf country with almost zero oil, but it foolishly acts as though it is brimming with oil, engaging in grand projects and huge debt fueled investments. The stock market has always assumed that Abu Dhabi would bail out its sister country within the UAE if there was a problem. Abu Dhabi has oil and could easily afford to bailout its sister, but maybe it is unwilling. This news has weakened the carry trade and in turn global stock and commodity markets. Latvia and even Greece are also close to defaulting on various kinds of debt. Remember, emerging market debt (EMD) is an end point in the carry trade; EMD is one of the major asset classes that shorted (carry trade) dollars are buying and therefore emerging market debt is integral to the entire phenomena.
The market thinks that Abu Dhabi will step in if more Dubai debt goes south and that the IMF will step in to help Latvia or Greece. If Abu Dhabi and the IMF behave as the market expects, then after a hiccup the carry trade will continue and (hopefully) the rally continues as well. Tapping the IMF does not erase bad EMD, it only transfer the debt from (for example) Latvia to Europe, America, and Japan. Abu Dhabi really can erase Dubai’s debt if it wants to. And they are part of the same country. The West is often confused about the United Arab Emirates. On paper, it is eight separate countries jammed hap-hazardously into one. In reality, Dubai is more like a province of Abu Dhabi, the leader of the UAE. The market knows all this of course and assumes that tens of billions of more bad debt from Dubai will get backstopped by the UAE’s leader. If this doesn’t happen, the carry trade will take a bigger blow and so will stock markets.