If factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Last week I wrote that the financials had broken down but the break might turn out to be a head fake. Stocks did rally afterwards but have since broken down once again, this time in a more convincing fashion. That's a big, red candle on the chart today. Considering the financials have led the the broader stock market for some time now, this is not a good sign.
Another chart I'd like to revisit is the Dow Transportation Average. In mid January I noted that the index was flirting with resistance at the 61.8% retracement level within what looked like a broadening top pattern. The index has since made a hard turn South.
This might have something to do with the weakness in the Baltic Dry Index, a measure of the cost to ship raw materials around the world and a key leading economic indicator. The Baltic never recovered to the same degree that the stock market did and failed over the past few months to surmount its November highs. Persistent weakness in this index contradicts the predictions of a strong recovery.
Finally, the dollar continues to rally signaling that the carry trade may be unwinding with a myriad of potential consequences for the financial markets none of which are benign.
Nouriel Roubini outlined what the unwinding of the carry trade might look like in an article for the Financial Times last year:
The current dollar rally/equity and commodity selloff may turn out to be the beginning of just such a scenario. All in all, it looks like a time for caution.