Carry Trade Helps Dow Soar

Traders came into Tuesday hoping that Bernanke & Co. would save the day again with some hint that another round of stimulus was forthcoming. Markets didn’t necessarily expect the Fed to actually announce a new round of quantitative easing or even the implementation of something called a “twist” operation (where the Fed sells short-dated bonds and buys longer-term bonds in order to push rates on the long end of the yield curve lower). However, there was a great deal of anticipation that, like last year, Bernanke would hint at the Fed’s next market-saving move.

But instead, the FOMC statement gave no such hint. Immediately following the announcement, stocks plunged as pundits argued that the Fed was out of bullets and/or that the situation wasn’t dour enough (yet?) for Mr. Bernanke to fire one of his last remaining shots. And since many felt that Bernanke no longer had any big guns in the closet, the fear was that stocks might sell off in earnest if the Fed tried to fight this fight with a handgun.

Sure enough, immediately following the announcement that the Fed sees a slowing economy, a crummy jobs market, and no real hope for significant upside going forward, the markets reacted. Stocks dove, bonds rallied, gold continued to soar, and the Swiss Franc – the mother of all flight-to-safety trades – blasted to new highs. Thus, it looked as if the market was telling us that since our white knight was no longer able to ride, it was going to get ugly again.

But then it happened. As is usually the case after a Fed report, the initial move was reversed. This wasn’t really much of a surprise but what happened from that point forward certainly was. And the only way to make sense of what happened next is to understand the inner workings of Wall Street banks, hedge funds, and the quants.

At 2:45 pm eastern time the Dow’s 1-minute chart (yes, believe it or not, you do have to have a one-minute chart up if you want to have a clue as to what is really happening during the day) hit the low of day: 10,604.07. This represented a loss of another 205 points and you couldn’t be blamed for thinking, “Oh dear, here we go again.”

However, at that precise moment the big boys and their computer toys went to work. You see, the braniac, global macro crowd figured out that the Fed had just handed them a gift – the gift of a no-recourse dollar-carry trade! And to sweeten the deal, Mr. Bernanke told the Wall Street faithful that they had a guaranteed 20+ months to work the trade. So, since the dollar-carry trade hadn’t been in mothballs too terribly long, it was easy to resurrect – and THIS is why stocks soared 635 Dow points in one hour and fifteen minutes.

To further explain, a “carry trade,” in which a trader (of substantial size – think a big hedge fund, a Wall Street Bank, or sovereign fund) borrows funds in one currency (via a short sale of T-bills) and invests the proceeds in a higher-yielding investment. For years, traders carried their trades in Yen due to the low interest rates. And then more recently, the dollar-carry trade has been all the rage given the Fed’s ZIRP (zero interest rate policy). To help put the importance of what is happening into perspective, understand that a “carry trade” is a staple of global macro hedge funds. It’s simply a type of trade that most of these funds use – to varying degrees, of course.

For example, some may have interpreted the MASSIVE dive in 10-year bond yields Tuesday afternoon (the yield went from 2.34% to 2.18% in 32 minutes) as a flight to quality. However, that wouldn’t explain the ramp of 600 Dow points (why would stocks be rising when traders are panicking into bonds?). No, what was really happening is the global macro traders were shorting T-Bills and buying higher yielding bonds with the proceeds. Note that yields on the 5-year and 2-year made dramatic moves as well. The 5-year yield dropped 23.6 basis points in 45 minutes, which is a 20% move! Thus, unless the world is suddenly coming to an end, the only way moves of this degree can occur is via program trades driven by the machines.

Another form of the “carry trade” is the dollar-carry/risk trade, which, in our humble opinion is what was behind the DJIA moving up from 10,604 to 11,240 in 75 minutes. Traders once again shorted the dollar and put the proceeds into risk assets such as stocks. And with the market as oversold as it was, the move basically fed on itself from there as the momentum crowd piled on and the shorts ran for cover.

So, before you allow yourself to believe that “everything is fine now,” that the worries over a global economic slowdown were silly, that Europe’s problems are behind us, and that it’s time to buy those UPRO’s on margin, you may want to think about what’s REALLY driving this move.

Turning to this morning… Overseas markets followed Wall Street higher and with the exception of Spain and Italy, European bourses are also higher. Rates fell at Italy’s latest T-Bill auction but the French felt the need to hold emergency meetings about the economy and talk about meeting austerity targets. Here in the U.S. the futures are pointing to a lower open.

On the Economic front… We will get a report on Wholesale Inventories at 10:00 am eastern.

David Moenning
Editor: The Daily Decision