Lesson on Carry Trade by Mike Larson

“Carry Trades” are dominating market action. Not just here. Not just in stocks. In virtually every asset class around the world.

But now, some troubling tremors are starting to emerge – and that could change the game!

So let’s address your first question right up front: What the heck is a carry trade?

Think of it like banking. A bank’s goal is to raise money cheaply from depositors like us, then take that money and loan it out at a higher yield to someone else. Paying out 1 percent on a CD, and loaning it out at 5 percent to a small business is basically a way for the bank to earn “positive carry” of 4 percent.

Things are more complicated in the global markets. It’s not just banks with a seat at the table, and it’s not just CDs or business loans. It’s investors of all sizes – all trying to borrow cheap money from a wide variety of sources, and investing that money in a wide variety of higher-yielding assets.

The strategies involved can be incredibly complex. But lately, some of the biggest carry trades have been those taking advantage of cheap yen and cheap euros. That’s because the Bank of Japan and European Central Bank have been doling out free money like Halloween candy.

So as part of this common carry trade, global investors will …

    1. Borrow cheap yen and euros (and to a lesser extent, borrow in many other currencies) …

    2. Sell those currencies and convert their funds into dollars …

    3. Then buy dollar-based assets that yield more, largely because the U.S. Federal Reserve has been talking tougher than its overseas counterparts.

That process has helped drive U.S. stock prices higher and higher in recent weeks. There has also been a negative side effect on commodities. Commodities often trade as “contra-dollar assets” – meaning they fall in value when the dollar rises. With the dollar surging, it’s been a bloodbath in gold, silver, copper, crude oil and other resources markets.

So what’s the problem? Can’t we all just sit back, buy U.S. stocks, short the yen and euro, dump energy and gold, and retire as millionaires?

Maybe for a while. But eventually, the rubber band gets stretched too far. Everyone and his sister will put the same trades on, and you get to the point where assets are ridiculously mispriced. When that happens, even the smallest bit of contrary news can lead to furious counter-trend rallies.

“The Bank of Japan and European Central Bank have been doling out free money like Halloween candy.”

I’ve seen it happen before many times in my career, and my antennae have been up recently, especially in the currency markets. As much as I think Japan and Europe have major problems, and the U.S. is in better economic shape, the yen and euro have gotten wildly oversold and the dollar has gotten severely overbought.

That means you have the preconditions for a sharp adjustment in place. Then overnight, China’s Shanghai Composite Index reversed sharply and dumped more than 5 percent on record-high trading volume of $128 billion. That was the worst one-day market rout in a half decade for a market that had been rising and rising despite weak, underlying economic fundamentals.

Other frontier and far-flung emerging markets sold off in sympathy, and the Japanese yen launched a sharp rally. As a matter of fact, the yen earlier staged the biggest rally since the spring. Gold and silver have also been seeing a “stealth” rally, and so have agricultural commodities.

Maybe this is a short-term thing. Maybe it’s just a small correction, and nothing more. But it’s worth watching whether this turns into something bigger. Because carry trades are great … until the moves get so large that the markets can’t carry their own weight anymore!

So let me know your thoughts. Have you heard of carry trades before, and does the potential reversal of those trades worry you? What do you think about the yen, the euro, and the dollar? Have we gone too far too fast, leaving us open to a big correction? Or do you think those moves have further to go? Finally, do stock market sectors like energy and gold look attractive to you after the beating they’ve taken in the past several months