Analysis from AdvisorAnalyst.com

The Key to Normalcy in World Markets?

The yen must replace the dollar in carry trades to restore normalcy to the global economy and markets, including Canada's.

For nine months we were trapped in the bizarre world of "bad news is good news." To the puzzlement of investors, stock markets rallied despite deteriorating economic fundamentals, negative GDP growth, 10%-plus unemployment, and the erosion of the dollar's value globally.

Here's why. When the Fed unleashed zero-interest rates, in conjunction with its quantitative easing policy, the U.S. dollar became the primary carry-trade funding currency for institutional traders and speculators. Traders could short the U.S. dollar and use the proceeds (i.e. borrow the money for next to nothing) to fuel their investing and speculating activity in higher yielding investments such as heavily sold off bank shares, commodities, emerging markets stocks and corporate bonds.

As long as bad economic news supported a belief that the U.S. dollar's value was set for erosion, carry-trading speculators could continue to borrow the dollar, by shorting it, thus driving it down further. A reversal of this trend, which fuelled the market recovery for nine months, would come in the form of good economic news supportive of the dollar. In the fall, reports of economic recovery, and calls from economists calling the end of recession started to emerge. Investors took these with a grain of salt.

What's ironic is that doomsayers like Nouriel Roubini, who called for the end of the dollar, were in fact, fuelling the carry trade, as their gloomy outlook stoked the trade. Massive amounts of invested money are at stake.

"Pi Economics estimated recently that the size of the dollar carry trade may have swelled to between $250 billion and $550 billion (U.S.) in the first half of 2009. Analysts say the yen carry trade grew as large as $1 trillion between 2004 to 2007," according to a Thomson Reuters report.

Some experts say the US dollar carry trade is not yet over, and that will depend on the health of the U.S. economy. It's too "early" to call the end of the dollar as a funding currency, said Marc Chandler, global head of foreign exchange research at Brown Brothers Harriman in New York.

On the other hand, if Japan's finance minister, Naoto Kan, has his way, drastic monetary intervention in the form of quantitative easing, to devalue the yen, will help Japan exit decades of deflation, and motivate domestic consumption.

Paul McCulley, Managing Director at PIMCO, goes as far as to firmly suggest that Japan should aggressively go "all in" with a deflation-busting quantitative easing agenda, by printing money, and cutting its overnight rates back to zero. Without saying so, McCulley is calling for drastic intervention in the yen, not only as a key to Japan's recovery from permanent deflation, but the global economy. At the end of the piece, McCulley's issues a tail-wagging-the-dog ultimatum.

"Markets don't wait. And if it becomes clear that the BoJ really does 'get it,' the currency markets will be way out in front of the BoJ," said Paul McCulley.

Reading between the lines, it appears that McCulley sees Japan's malaise as a way out for America. An aggressive move on Japan's part, to boost global liquidity, would help America clear its decks. Its McCulley's best attempt at "win-win economics."

In the same vein, some countries have become downright impatient about their own economic interest, and have intervened this week, buying dollars. The Globe and Mail reports that at least four of China's main competitors in Southeast Asia bought dollars Monday, in order to counter China's "beggar thy neighbour" policy, that protects its domestic interests at the expense of others.

The list included India, South Korea, Singapore and Indonesia – big trading nations that risk losing ground to China as the dollar falls because that country has insisted on tying the value of its currency to the greenback since 2008 to shield its economy from the global recession," wrote the Globe's Kevin Carmichael. This sort of sovereign intervention could precipitate a rally in the dollar, acting as a tipping point, by squeezing those who are short the dollar.

A more valuable dollar makes the exports of countries like India, and, for that matter, Canada, more competitive, provides dollar reservist countries with a monetary boost and breathing space, and the resumption of the yen carry trade provides the world with a new money bridge (liquidity) and therefore, time for an orderly transition in markets, back to normalcy.

Finally, good news will be good news, again.