Dollar Carry Trade

Charts: The S&P 500 closed at 1045, up .2%. The market is in a correction. The last two days action represent a rally attempt.

Fundamentals: M&A activity buoyed stocks today plus factory orders came in stronger than expected. Besides strong manufacturing data the global stock and commodities rally is also being fueled to some degree by a US dollar carry trade. This means that investors are shorting the dollar on margin and buying emerging market debt/stocks, commodity futures, and other risky assets. The carry trade investors are effectively borrowing at a negative 20% interest rate, making piles of cash so far. But it has become a ubiquitous bet of massive proportions. The link between the dollar going one way and the S&P 500 going the other (inverse correlation) is now about 70% and rising. Historically the inverse correlation is in the single digits. All major global financial movements are taking their cue from the dollar. Professor Roubinin says that this link must break down at some point because the dollar cannot drop to zero. He predicts that when the dollar stabilizes there will be an immense sell-off in risky assets (the bubble popping on dollar short covering) although Roubini does think the bubble may keep expanding for a while. Other economists predict a gradual unwind of inverse dollar linkage and are more bullish. The yen carry trade lasted 5 years in the previous bull market.

Geopolitics: There is evidence that the US Army opened the borders between Afghanistan and Pakistan, allowing perhaps a few thousand extra Taliban fighters into South Waziristan at the beginning of the war a couple weeks ago. The Pak Army made the original assertion and now claims that the US Army has sealed the border and bad guys are no longer streaming in. If all of this is true, then it is certainly was a brutal move on America’s part. It forced the Pak Army to kill more bad guys then they would have otherwise, spilling more good guy blood than initially planned. The alliance got a bit frayed over this move. The Pak Army felt better after India moved a division out of Kashmir.
Team Obama has abandoned its strongest diplomatic effort: The demand Israel halts its West Bank building program. The Team caved in because of problems with its domestic agenda. It couldn’t stick its neck out diplomatically against Israel while healthcare flounders.

Specific Investments: The Ridgeworth ultra-short government bond fund (SIGVX) pays 3.5% interest and is rated by Morning Star as low risk. Only cash is risk free, but cash is paying negative real interest rates.