Understanding (and Playing) the Dollar Trade
January 23, 2010
On Tuesday, stocks rallied unexpectedly in response to the possibility that Republican Scott Brown could win the special Senate election held in Massachusetts. The triple-digit gain that seemed to come out of nowhere discounted the potential for gridlock to return to Washington, which, as market historians know, is much preferred to either party running the entire show. But then after the victory was achieved, stocks took a dive to the downside Wednesday and many investors were left scratching their heads.
While there were some negative stories Wednesday morning such as the Chinese telling banks to halt lending money for the month and the earnings from the banks here at home coming in a little light in the revenue department, the real story behind the dance to the downside on Wednesday (and then again early on Thursday) was the rally in the dollar.
Understanding the Dollar Trade
There are two parts to the dollar story this week. First, there was the unexpected consequence of the Republican’s victory. While most everyone went to bed Tuesday night dreaming of green screens for stocks on Wednesday, the fact that the Democrats had lost their “super majority” in the Senate meant that they could no longer pass anything and everything into law. To those forward thinking currency traders, this meant the potential for lower deficits and less debt to be issued by the good ol’ USofA, which, in turn, meant higher prices for the dollar.
The second part of the dollar rally story is the trouble with sovereign debt in Europe. In short, the ongoing difficulties in places such as Greece continue to put pressure on the Euro. And the way the currency game works, a decline in the Euro means an increase in the dollar. So, while the U.S. may have a relatively untidy fiscal house at the present time, it may still be the best house in the neighborhood.
Why should we care so much about the dollar? In brief, because THE trade in the hedge fund world has been to be short the dollar and long “risk assets” such as stocks, commodities, and the emerging markets (the latter two areas benefit from a falling dollar due to the nature of the investments). Thus, any increase in the dollar puts pressure on this trade, which forces some folks to “unwind” the trade by buying dollars and selling the “risk assets.”
In addition, back in mid-to-late October, investors were introduced to the concept of the dollar-carry trade and the potential risks it presented to investors if the trade started to unwind prematurely. With the idea of borrowing in dollars and investing stocks, commodities and emerging markets having become all the rage amongst the big-money crowd, Nouriel Roubini opined at the time that “there could be a market crash all over the world when the U.S. dollar reverses.”
Understanding the Players
If you are like me, you may be wondering who are these people that can borrow from the Fed at 0% interest and invest the proceeds of the loan into these so-called “risk assets?” Sure, foreign banks can pull this off easily, but based on the amount of capital these entities have invested in the U.S., this wouldn’t seem to present the massive secular risk Dr. Roubini is concerned about.
So the question becomes, who besides foreign banks can borrow from the Fed at 0%? If you jumped out of your seat and yelled “Goldman Sachs (GS),” go ahead and award yourself a gold star! Remember, the big Investment Banks on Wall Street morphed into commercial banks during the Credit Crisis. Thus, they can now borrow from the Fed. And oh, by the way, they do a little trading of their own.
With the big boys on Wall Street having access to the Fed’s discount window, they have access to funds at next-to-no carrying costs – talk about a margin account! Thus, one of the unintended consequences of the Fed keeping rates at 0% in order to give the banks the opportunity to rebuild their capital base quickly is that the Fed becomes the source of capital for some very big players.
Why You Should Care
You may still be wondering why you need to care about this stuff. (But, make no mistake about it; the bottom line is you DO need to care if you invest in the stock market.) The answer is that the program trades that take stocks down 100 points in 15 minutes are not run by mom and pop traders. These programs are not run by the day-traders working out of their homes. And they are not run by mutual funds or pension managers. No, these programs are run by the very biggest of the big boys. And if we learned anything this week it is that these programs are tied to the movement in the dollar right now.
One way to think about this situation is to envision this trade as “pair trade” that is put together by computers. And as a matter of risk management, the short dollar/long stocks, commodities, and emerging markets trade also has an inverse trade built to be run when things go the other way. You can think of this as a very sophisticated “stop” order that involves several moving parts and some big computers.
Yes, it is true that politics entered into the mix on Thursday when Obama launched into his latest rampage against the banks (frankly, I still don’t understand why the President thinks picking a “fight” with the nation’s banks is a good thing). And it was politics that created much of Friday’s shellacking. But up until that point, the big, fast moves in the market were, in our opinion, program driven trades that were tied to the U.S. Dollar.
One of our major investment themes is that we need to understand “why” things are happening. While I’ve mentioned this a time or two hundred, our thinking is that if we can grasp what is driving the market on a short-term basis, we are unlikely to be surprised when the market’s big picture environment starts to shift.
Thus, in light of the fact that our 2010 roadmap includes a substantial correction at some point during the year, we are on the lookout for anything that will cause the bulls to step aside – even if for just a few months. And in our humble opinion, this dollar trade could be just the trigger our furry friends are looking for.
You Too Can Play the Game
If you are so inclined and want to get into the action, you too can play this game with ETFs. For example, if the dollar breaks above an important resistance zone, it is a fairly safe bet that stocks will move lower. So, if the UUP (PowerShares DB US Dollar Index ETF) moves over $23, you could buy the UUP and at the same time go short the U.S. Stock Market via the ProShares Ultra Short S&P 500 (SDS), the emerging markets via the ProShares UltraShort Emerging (EEV) and the commodities index via the ProShares UltraShort Commodity (CMD) or by shorting the DBC itself. Voila, you’ve got yourself a trade designed to profit from the dollar-carry unwind.
Finally, this brings up a key point. The short dollar/long risk assets trade was VERY popular last year. Thus, it makes sense that if the dollar begins to rally, the opposite trade might become all the rage. And since the hedge funds these days tend to gravitate toward ETF’s, you can see how easy it is to implement such a trade – even for the little guys!
Wishing you green screens,
David D. Moenning
Founder TopStockPortfolios.com
Positions in Stocks Mentioned: None
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