Dollar Carry Trade in Vogue -- for Now

EUR/USD has continued to rally and the negative correlation between the U.S. stock market and the dollar remains in place. The standard explanation for the correlation is that hedge funds and other big traders see the rising stock market as a confidence-building "green light" for them to return to the leveraged trades that made them a lot of money pre-2007 but were unwound quickly once the credit crunch hit.

The idea is to borrow cheaply and use the proceeds -- leveraged up to 20 times -- to invest in higher-yielding assets. In other words, the "carry trade." For the first time in 16 years, short-term U.S. dollar interest rates have fallen under those of Japanese yen, thus making dollar borrowings the cheapest funding vehicle for carry trades into higher-interest rate currencies such as the Australian and New Zealand dollars.

The result is on-going pressure on USD as traders short it (borrow) and buy (invest) into the high yielders. All is well for the carry trades as long as the U.S. dollar stays steady or, preferably, continues to decline. What would catch them out would be strong rally in the dollar. And that brings us back to the correlation between the dollar and the stock market. i.e., a fall in the stock market will cause a rally in the dollar, or perhaps vice versa.

My analysis of the currency markets suggests that the dollar is close to a bottom of some significance. In terms of EUR/USD -- as shown in the chart below -- a final push up toward the 1.5000 level should be it for a while, giving way to a selloff back toward the mid 1.3000s. Thus, some excellent currency trading opportunities are at hand.

Tracking the Euro vs. Dollar Source: Max McKegg

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