Unintended Consequences
Jeffrey Simon

 

The unwinding of the carry trade may be having far reaching and unintended consequences.  Recall that the carry trade is the borrowing of money at low short term interest rates and reinvesting those funds into investments that are expected to yield a greater return than the cost of the borrowed money. The borrowed carry trade money is invested in all regions of the world.

On May 10, 2004 The Financial Times ran an article entitled: “Debt traders fear ‘meltdown’ aftermath.” Occasionally I will read an article that really puts things into perspective for me; this was one of those articles. My take on this article was that the unwinding of portfolio flows and selling of international investments may threaten international currency stability and bond markets.

Yield spreads between the “more risky” foreign markets and US Treasuries narrowed as funds flowed into the foreign bond markets. In purchasing international bonds the US dollar was sold and foreign currencies were purchased. The reversal of this transaction, in response to expected higher interest rates in the United States, has the potential to wreak havoc on all markets, foreign and domestic. Diminished demand for foreign assets may trigger a financial crisis similar to those that occurred in the mid and late 1990’s.

In those crises asset prices around the globe began to fall until a virtual circle took over. Selling begat selling as increasing numbers of participants saw the value of their portfolios erode. Asset price erosion is hurts the most when the assets are purchased with borrowed funds and extreme leverage; both of which are currently present in the markets.

In one spectacular case the Federal Reserve was forced to intervene to prevent a greater financial market meltdown.  In another case the Federal Reserve responded, as it always does, by opening the liquidity spigot. Given the monetary spigot is already wide open now how will they respond this time?

An unwelcome chain of events may be unfolding. There is a rush to sell assets in exchange for US dollars with which to repay borrowed funds. As portfolio funds flow out of financial markets interest rates will rise to try and retain the portfolio flows. The potential scenario is the rising interest rates in several countries chokes off economic activity, perhaps on a global scale.

Meanwhile, the United States remains at war and continues to run enormous and growing federal budget deficits. In the face of slowing economic activity, the percentage of US GDP that the deficit represents soars to record highs. Confidence in the US dollar will eventually begin to wane and money will once again flow out of the United States, most likely into the precious metals of gold and silver as a way to preserve purchasing power.

The path to this end may be uncertain, but this is the path I think we are on. If only I had a crystal ball I could specify the time frame in which I expect these events to unfold, but alas, like you, I do not.

One final note: much press has been wasted this week deriding Warren Buffet for moving assets into foreign currencies, but the one thing the mainstream press seems to have forgotten is that, of all investors, Warren Buffet is probably the most patient. In the end it is he who will have the last laugh at the folks who, on the basis of short term thinking, deride him. I for one am following his lead and will continue to keep my holdings diversified over several currencies.

Market Action

Dow Utilities, Dow Industrials and Dow Transports

The Dow Industrials closed today at 10,045.16, down 265.79 from last week.

The Dow Transports closed today at 2,847.34, down 75.67 from last week.

The Dow Utilities closed today at 262.14, down 11.77 from last week.

An oversold market that does not rally is a dangerous market. Today, finally, some of the markets rallied; the Dow Industrials after being down 167 points closed up 25 points. At the low today the Dow Industrials were lower than any intraday low since December 18, at the close they were above the highs of yesterday. Therefore, today can be classified as a key reversal day. The question is how much strength this key reversal will lend to the current rally. I would have more faith if the advancing versus declining stocks was more positive; on the NYSE there were 1439 advancing and 1402 declining stocks. It will be interesting over the next few days to see if the rally can widen and increase its breadth.

A positive factor for the Dow Industrials is the fact that the Dow Transports, in spite of rising energy costs, have thus far not confirmed the low in the Industrials. At 2847.34 the Transports are still 97 points above the low of 2750.80 set on March 22, 2004. The failure of the Transports to confirm the low may be a good sign.

From here I would feel more comfortable if the Transports rallied and achieved several closes above their 50 day exponential moving average, currently at 2901.25. Even more encouraging would be if the Industrials joined the rally and managed several closes above their 50 day EMA, currently at 10,325.51.

As a negative factor, the Dow Utilities did confirm the Industrials move to a lower low. Due to extreme sensitivity to interest rates the utility stocks tend to lead the market and this move to a lower low has potentially ominous implications. I am inclined to heed this warning and will continue to remain an observer from the sidelines.