Welcome To Hell

The last week or two I had noticed that the /DX (dollar index) had a somewhat-odd correlation to the stock market - one that had not been present to the same degree, if present at all, before.

Specifically, it would move just before the /ES - S&P futures - moved, and the correlation between the two was almost lock-step.

I had mentally blocked out the worst of the possibilities until last night, when it was said right up front by a user who had lunch with a banker in Australia: The dollar has become a carry-trade funding currency; he was executing an increasing number of these trades with the dollar.

We are following Japan's script almost exactly, but our trip down this road will be far worse than it was for them, because as a nation we are monstrous net importers and in tremendous debt, both as consumers and as a government, where Japan is a net exporter and their population is full of savers.

Tuesday I wrote about the dollar decline powering this latest ramp job in equities, but this development, if it has become or is widespread, is a major problem for The United States, and opens the yawning maw of a trap that we will find it tremendously difficult to escape from.

Japan has been essentially trapped at zero interest rates and moribund economic growth - essentially zero - for more than a decade.  The Carry is a big part of that, as it depresses the currency, since the carry is essentially a short on the funding currency.  As traders press those bets the currency comes under increasing pressure, which increases import prices (but makes exports more attractive), draining resources from the "host" country that has become the funding currency.

Putting a stop to it means raising interest rates even if the consequence would be a severe economic recession or worse, and the longer it goes on the worse the damage in the form of structural distortions in the economy is.  But refusing to raise interest rates means that not only does the distortion continue but the damage from ZIRP continues as well - borrowing no longer becomes a function of interest cost .vs. marginal utility but rather simply a matter of whether you can find someone that will let you borrow at all.

Carry trades can also unwind due to exogenous (not interest-rate) pressures - should there be a sharp upward spike in the dollar these trades suddenly (and very painfully) go "underwater" as the currency translation is an integral part of the profit (or loss) in the transaction.  This "unwind" feeds on itself as to liquidate the carry you must buy dollars, which in turn adds yet more upward pressure on the currency, which makes the spiral tighten even more.  This is what happened to Japan over the last year as the crisis deepened, and it decimated their exporters (and stock market) last year.

The paradox is that you'd think this would create tremendous inflationary pressures.  But that's not what has happened in Japan - they wound up with incredible deflationary pressures instead, because consumption became much less desirable than export!  As such the policy "prescription" becomes yet more easing, but with interest rates at zero the policy folks are left scrambling for yet another knob to turn of some sort.

In the United States this will be ugly, because we're not an exporting nation.  Instead of being able to "prefer" export we are instead likely to find quite-crazy ramps in certain import prices, specifically oil.  That in turn makes economic recovery nearly impossible, as it sets up even more structural dollar flows out of the country.

Nor is this supportive of asset prices in the intermediate term.  Sure, it looks good when you get a 7% stock market rally when this begins, but have a look at the Nikkei - their market topped at 40,000 and has never been anywhere near there since.  Real estate prices have not recovered their previous highs and remain moribund, and the former "never get laid off" Japanese economic model has been laid waste, with generations-long policies abandoned as simply unworkable.

This is something we should not have allowed to happen but we now have, and it is now incumbent on The Administration and The Fed to put a stop to it before it becomes pervasive.  Determining exactly how much "carry" is out there is difficult; if The Fed has a handle on this they sure aren't going to divulge it, just as Japan's Central Bank never has, but the impact, especially when you get forced unwinds, are vicious and impossible to ignore.

For those who said "we won't make the mistakes Japan did" let me point out that we have indeed made all of the same mistakes and now we're getting the same results.

Why is it that Einstein's exhortation continues to echo in my head?

Insanity is doing the same thing over and over but expecting a different result.