Carry trades to hit a bump in the road or?

A carry trade is if you borrow money to invest. And obviously the cost of borrowing should be lower than the expected return on the investment. The "dollar carry trade" has been very popular in recent months. With dollar interest rates close to zero and the dollar depreciating against most other major currencies it has been obvious to borrow in dollars. This has led to a continued depreciation of the dollar, and so on. The investments? Well, just about anything would do, so let us just assume that investors have been investing in some of the assets that have profited from the recovery. Assets - stocks and corporate bonds - that have increased as the companies moved to rebuild profitability in the wake of the sharp downturn.

This Friday's report about the sudden improvement in the US labour market was a surprise. It was published right in time to improve the mood for the holiday shoppers, and politicians will hype it to make us believe that this was the turning point in the recession. No matter that there will be significant revisions showing that the data probably were erroneous. The revisions will only come after the holiday season...

Whether this is conscious manipulation of data or not, there has been another side effect of the report. Worldwide, central bank officials have been busy over the past two months to make sure we all understand that interest rates will not be tightened until the economic recovery is robust. With the publication of the labour market report the market began to reconsider this. Forward curves show that on average, the market now expects Fed to push up policy rates in August 2010 instead of September same year. As a result the dollar rose almost two percent in trade weighted terms, a quite significant move given the long period of a sagging dollar.

While this is all rather technical, the effects may actually prove to be important, as it is the first indication that the risk appetite may be falling. To those who established their positions in time, having invested in the stock market and borrowing in USD has been a one-way street for much of the year. Friday's strong move in USD served as a timely reminder that the market does not offer any free lunches but that all investments are risky.

The point is now whether this bump in the road is enough to wean investors off the carry trades. Probably not, but the story is out now. Add to this that the USD probably by some measure is undervalued (Just think of the number of Europeans going stateside holiday shopping). Friday's reaction also gave the indication that once investors want to close these trades, the market movement can be swift and merciless. I do not want to sound alarmist, but this issue has the potential to be one that really could roil the market.