Analysis from AdvisorAnalyst.com

The Prevailing Trend, The Dollar, and the Return of Volatility

What does the fiscal crisis in Greece have to do with the price of commodities? Why would the Chinese step up their rhetoric of ditching reserve holdings in U.S. agencies, like Fannie and Freddie, and mortgage backed securities debt – Whom does it serve?

Why have emerging markets, commodities and commodities stocks, and equity markets in general, gotten a lashing?

Believe it or not, it's all about achieving global equilibrium, and at the heart of this is the dollar.

Behind all of the market volatility in equities, commodities, and emerging markets in January, and the myriad of causes the financial media chalk up, are the prevailing trend, and the countervailing forces, that revolve around trading in the U.S. dollar.

The following charts show the U.S. dollar ($USD) (on top) vs. TSX (S&P/TSX composite), EEM (iShares MSCI Emerging Markets ETF), and $CRB (Reuters Jeffries CRB Index). You can see a clear inverted relationship exists between the dollar and these three assets. This relationship, by the way, extends to most of last year's winning trades, and explains much of the correlation between them.

For most of last year, with policy interest rates at zero and the U.S. economy faltering, global speculators could borrow the U.S. dollar for next to nothing, and invest it in risk assets such as commodities, emerging markets and income paying securities such as guaranteed agency and corporate debt.

With the economy turning the corner as early as last fall however, markets went range-bound. Ironically, it is the U.S. economic recovery that is to blame for last month's selloff and is behind the prevailing trend of the strengthening dollar.

Good economic news however, is putting the squeeze on carry traders who borrowed the dollar last year, by shorting it, from the latest of these trades, to the earliest. In early December, David Rosenberg warned the counter-trend rally in the dollar was overdue, adding, "The commodity complex will come back, of course, but for the time being will be in a corrective phase. This is not an end to the secular bull market but the speculative longs have to be shaken out and the short squeeze in the dollar has to run its course."

Since late November, the yen promised to replace the dollar as the primary funding currency, as the Japanese economy sank further into deflation, and the Bank of Japan cut its policy rates to 0.1 per cent, slightly lower than U.S. policy rates. For a little while at least short covering in the dollar, was offset by traders extending short yen positions, and that provided some balance, in what would otherwise have possibly been an earlier correction that some market observers were calling for late last year. Japan's woes were providing a bridge across the risk chasm. You have to realize that the carry trade is a much bigger force to reckon with in the market, than most people know, and when it collapses quickly because of economic imbalances, the consequences have the potential to be extreme, because of the size of the stakes.

"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.

So remember, things were going relatively smoothly as the yen began its tenure as the new funding currency of choice for carry traders. The dollar, gold, equities, and bonds were rising at the same time for about three weeks during December.

Then along comes Greece, overlevered and unable to meet its balance-of-payments, and with it, the scare of a fiscal flu epidemic in the PIIGS (Portugal, Ireland, Italy, Greece and Spain, as they have lovingly become known). The euro tanked as concerns reached a crescendo on the idea that there would or should be no intervention. Traders had apparently taken out $8-billion worth of trades against the euro.

As a result, the dollar climbed rapidly relative to the euro, and this tightened the short squeeze in the dollar, forcing a more rapid unwind of dollar funded carry trades. Even short yen positions which were just begun in November and December have unwound. The end result is a higher dollar and yen, than some, like China, would like.

The bottom line is that these short squeezes in yen and dollar carry trades are the cause of the volatility and downward pressure on markets during the last month. Unwinding currency pairs is one thing, but when so much of the carry trade is tied up as it is and has been, long commodities, oil, gold, emerging markets, things can get ugly really fast, and they did.

At the time of writing this, stocks rallied on the news that Germany and France would bail out Greece, but gains were pared later in the day by word that Bernanke may raise the policy discount rate.

Pay attention to the following currency pairs – USD/EUR, USD/JPY – If either or both of these continue rising, risk assets will continue to come under pressure. Depending on what solution the EMU decides on, the short squeeze, this time, could leave (euro) currency speculators nursing losses.

As well, the advent of deleveraging, debt deflation, and fiscal policymaking this year are likely bearish for markets and bullish for the U.S. dollar. There are those for whom a stronger dollar is a favourable development, and also those for whom it is undesirable.

Stay tuned. The next instalment will cover China's countervailing agenda.