Has the carry trade been unwound?

One of the fascinating features of the massive selloff of risky assets this year has been that it appears to have a lot to do with the unwinding of "carry trades" put on in the years prior. According to the "carry trade" theory, easy money and low interest rates encouraged investors all over the world to borrow or sell dollars and buy assets such as houses, other currencies, gold, commodities, equities, and oil. Eventually the prices of these things reached untenable levels and began to reverse, with the first bubble to pop being the U.S. housing market. Falling housing prices then triggered the collapse of subprime mortgage-backed securities, which in turn prompted the collapse of the banking system and eventually the sharpest decline in U.S. equities since the Depression. This year we have seen massive declines in equities, nondollar currencies, commodities and oil, suggesting that investors and/or speculators are unwinding their carry trades: i.e., selling risky assets and buying back dollars.

This chart puts some flesh on the theory, showing that there has been a strong negative correlation between changes in the dollar and equity prices (with a stronger dollar corresponding to falling equity prices). That the dollar appears to have topped out at the same time that equities appear to have bottomed suggests that the unwinding of the carry trade may have largely run its course.

Another way to see the significance of this chart is via the lens of monetary policy. With investors and speculators all over the globe rushing to reverse carry trades, the demand for dollars was intense. The Fed was slow to respond to increased dollar demand, apparently, because the dollar strengthened sigificantly as risky assets collapsed. But recently the Fed has gone into full quantitative easing mode, with the result that the Fed's balance sheet has expanded by orders of magnitude and the Fed is doing its best to supply all the dollars that anyone could possibly want. Meanwhile, frantic selling by hedge funds and investors has kept the demand for dollars strong.

Now that the supply of dollars has caught up (or perhaps surpassed) the world's demand for dollars (and distressed selling pressure appears to have abated), this corrects one of the most severe underlying problems the economy faced this year, since without this action by the Fed we could have found ourselves in the grips of a true monetary deflation deja vu. And that could have validated all the fears of another Great Depression that were built into equity and corporate bond prices.

So a weaker dollar (and stronger gold) could be prima facie evidence that the underlying fundamentals of the economy are improving. It's no wonder that the equity market is beginning to show signs of life again.