Tuesday, March 3, 2009

Has the carry trade been unwound? (3)

I haven't had much luck with this theme (if being wrong is unlucky), but the enduring and strongly negative correlation between equities and the value of the dollar looks too interesting to ignore. This chart seems to be saying that strength in the dollar is very tightly related to weakness in equity prices and vice versa. Does that help us understand what is going on it the markets?

My first attempt to explain this relationship theorized that it was all about the unwinding of the carry trade. The world got massively short dollars in the past several years, and loaded up on housing, commodities and other currencies. When the financial crisis hit with full force last year all of these trades had to be unwound, and the market was dominated by massive dollar deleveraging. Dollars were in short supply, since all those who had levered up previously were now trying desperately to reacquire dollars, so the dollar's value rose as the prices of commodities, housing, and other currencies fell. And that shortage of dollars was bad for the economy, so equities fell. The Fed's aggressive attempts to use quantitative easing to relieve the shortage of dollars weren't quite enough to avoid a continuing shortage of dollars.

I'm not sure now that this is a convincing argument. It's hard to believe that there is a shortage of dollars given the massive expansion of the Fed's balance sheet and the monetary base. It's hard to understand why the dollar is viewed as a the currency of choice, when the entire global economy slides further into recession and the Obama administration is looking to raise taxes on capital and on the most economically productive segments of the economy, not to mention the likelihood of there being trillion-dollar deficits for years to come.

Meanwhile, while I continue to think this through I'll welcome suggestions from readers.

2 comments:

The Lab-Rat said...

http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1

achille said...

My assumption is that the dollar has been strong because the demand for US government debt has been high. The demand for US government debt has been high for the following reasons:

a) Overall, the market continues to expect a deflationary environment near to mid term implying that the value of assets and commodities will fall.

b) People thus seek things with fixed nominal values (and thus rising real values in a deflationary environment), namely debt denominated in or holdings of the world's fiat reserve currency, i.e., US dollars. The US dollar's reserve status gives it an advantage of other currencies in this respect given that it ensures i) that, like gold in more difficult times, US dollars are the world's "unit of account", and ii) a based level of demand for US dollars.

c) Investors are looking for something with negligible default risk - the excludes corporate bonds, and bank deposits (which are insured only up to $250K or whatever it is currently). The only thing left is US government debt.