Clive Corcoran's  Instablog

There has been a lot of commentary recently about the inverse relationship between the US Dollar and the S&P 500. What is perhaps more extraordinary from an inter-market analysis perspective has been the very strong correlation between one of the principal carry trade pairs - the Australian Dollar/Japanese Yen - $AUDJPY - and the MSCI Emerging Markets Index.



Using the daily changes in the exchange traded fund, EEM, and the daily changes in the North American closes for the cross rate, it is possible to derive the correlation coefficient value and the chart above shows the result of the linear regression from the beginning of January 2007 through the close on October 30, 2009. The coefficient of determination or R squared value for the relationship is approximately 0.62 which is one of the highest positive associations that I have encountered between a currency and an index.

An alternative way of considering the relationship is to normalize the paths taken by the two instruments using as an index base the values as of January 3, 2007, and placing the trajectories on the same 2 dimensional graph. The graphic below shows the remarkable extent to which the paths taken are correlated.



So why should we be interested in such correlation measures and pretty diagrams?

Because they underlie one of the least well understood inter-market relationships that drive global capital flows - the forex carry trade.

The episodic strength of the US dollar against most other currencies, except the Japanese Yen at times of financial unease reflects the fact that these become the sought after currencies when traders/investors lose their appetite for risk. It is both a symptom of, and a contributory factor to the periodic dislocations in the carry trade.

Put simply if the carry trade begins to lose its appeal - and both legs of (say) the Aussie/Yen trade are going in the wrong direction from the point of view of those long the carry trade - then there is a period of rapid unwind which will be very disruptive, especially for those asset classes which are being funded by financial engineering predicated on the carry trade.

Let us return to the high R squared value. This has existed across the almost three year period under review and shows that when the currency pair increases i.e. many are using yen borrowing to fund Aussie dollar purchases there is a high propensity for purchases of emerging market assets to increase.  Also the converse is true when the appetite for the currency pair drops so does the EEM.

In the last few sessions (at the end of October 2009) the currency pair has been exhibiting some very erratic behavior. It might colorfully be described as like a roller coaster ride with spectacular waterfall like features for the passengers being carried to get a really good soaking when the unwinds become frantic.

As the carry trade loses its appeal so does the appetite for risk assets and this becomes part of the larger framework in which dollar strength - resulting not only from the actual unwinding of many other currency pairs but also from the flight to safety mindset - is most decidedly not a positive for global equities.

Tim Bond is an asset allocation manager at Barclays Capital and has recently issued an upbeat note about the global economic outlook. To Mr. Bond it appears that the recovery is on track and we should take comfort from the fact that those who could not get enough of safe haven assets until the end of Q1, 2009 - such as Treasuries and US dollars in general - are now rushing headlong into more adventurous asset classes again.

His argument essentially is that the drop in Treasuries this week, the ailing dollar and the reflation in the commodities market is actually a reason to be bullish. He doesn't quite get around to talking about trillion dollar deficits and the possibility of sovereign defaults but, to be fair, you can't cover everything in a note to clients.

Here is the abstract from his piece which is worth reading and a link can be found here .

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The One Trillion Dollar Headline for the IMF's future funding on the G20 press releases is already in trouble as the following news release makes clear. The IMF is now joining the queue to sell bonds to raise the money that was "pledged" at the meeting at the beginning of April in London.

WASHINGTON (AP) -- The International Monetary Fund will sell bonds as a way to raise funds to lend to struggling nations, the head of the organization said Saturday, in a victory for developing countries.

Emerging economies such as China, Brazil and India pushed for the move as an alternative to providing longer-term loans to the IMF. Those countries want a greater voice in the institution before providing additional resources.

IMF Managing Director Dominique Strauss-Kahn said China and other countries have expressed interest in purchasing the bonds. The IMF has never issued bonds before, although the idea was explored in the 1980s.

The move, announced after the IMF's annual spring meeting, indicates the world's leading economies are having difficulty following through on a pledge made in London April 2 to boost an IMF emergency lending facility by $500 billion. The bonds will contribute toward that goal but will provide shorter-term financing than the loans that Japan, the European Union and the United States have promised.

The final paragraph makes clear that one of the alleged positive contributions that arose from the G20 gathering was actually little more than a catchy headline where all of the heavy lifting still has to be done.