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
