Forget China, Circumstantial Evidences Reveal the Unwinding of Carry Trades

In the US, there have been numerous “rationalizations” floated as the reasons for the current “shock” or the reappearance of volatility.

Some attributed it to the comments of former Fed chief Alan Greenspan who uttered the “R” word on Monday in a business conference in Hong Kong in front of group of private investors. Because Mr. Greenspan possibly felt that he may have influenced the recent activities, he quickly clarified his position on Thursday saying that, as quoted in Bloomberg, ``By the end of the year, there is a possibility, but not a probability, of the U.S. moving into a recession.”

Like our previous observations, Greenspan noted of the legions of risks that have been dismissed by the cheerful consensus, where according to the same report by Bloomberg, ``Current low yield premiums aren't sustainable, profit margins are peaking and the U.S. growth cycle is in a mature phase, Greenspan said today. The former Fed chairman said previous experience suggests a flattening of profit margins should produce a recession.”

There are also reports that technical glitches in the Dow Jones Indices helped exacerbate Tuesday’s biggest decline since 2003.

Of course, I don’t buy these myths, analyst Barry Ritholtz aptly wrote to debunk every bit such “rationalizations” in his article the “10 myths in Tuesday’s Correction” whose conclusions I would share (emphasize mine),

``Since the summer, the rampaging bulls have had their way with just about every market on earth. Volatility had been subdued and risks ignored.

``That era is likely over now. Indeed, the general commentary ("buy the dip, hold for the long term") may be ignoring a developing shift in psychology. It reeks of complacency.

``In a note to clients after the plunge, we said to expect three things:

1) Increased volatility;

2) attempt(s) to return to prior market highs;

3) deeply oversold conditions that will eventually create great entry points.”

Now moving to the UNSEEN, here we have one phenomenon that appears to have taken place coincidentally, as the market soldoff. It is something that we have prominently discussed in the past and the issue is no less than the CARRY Trade.

Figure 3: Stockcharts.com: Unwinding Carry Trades? The Funding Currencies

Two funding currencies or currencies arbitraged to finance investments in other asset markets, the Swiss Franc (lower pane) and the Japanese Yen (superimposed) rallied furiously as global markets were sold down the drain, the Swiss Franc was up 1.36% (w-o-w) while the Japanese Yen soared 3.73%. Since the world markets have essentially been highly correlated with the US benchmarks, I placed the Dow Jones Industrial Averages as representative (candlestick).

Figure 3, tells us that the rally has been simultaneous in terms of timeframe [blue arrows] and correlated in terms of magnitude [degree of rallies of the Yen inverse to the degree of decline in invested assets.].

Figure 4: Stockcharts.com: Unwinding Carry Trades? The Invested Assets/Currencies

In Figure 4, the invested asset/currencies which benefited mostly from the Carry Trade, the South African Rand (upper window) and the Australian Dollar (lower window), as well as the emerging Market MSCI benchmark (center chart) have likewise shown a replication of activities albeit on an inverse scale relative to timeframe and magnitude.

Put differently, while there have been incessant blathers about what’s driving today’s markets, it looks as if the dynamics of the unwinding of the Carry trade similar to May of 2006 has played a big PART among the variables involved, as the circumstantial evidence above suggests. The US and the world markets appear to be at the short end of the unraveling of the Carry Trade.

And this is not without precedent, Mike Larson of Money and Markets, ``It’s happened before, most notably during hedge fund Long Term Capital Management’s (LTCM) meltdown in 1998. The yen surged 9% in a matter of weeks that summer, then skyrocketed another 12% in just 72 hours!” Déjà vu?

However, I wouldn’t venture into justifying these as the CAUSAL factors lest be accused of another logical fallacy Cum Hoc, Ergo Propter Hoc” [With this, therefore because of this]. We will have to see if the trend continues to play out in the following weeks.