One of the biggest issues investors need to assess today is the US Dollar carry trade.
If you’re unfamiliar with the concept of a carry trade, it occurs when you borrow in one currency, usually at a very low interest rate, and then invest the money in another security, whether it be a bond, stock or what have you, that is denominated in another currency.
More often than not, you invest directly in the other currency itself, pocketing the difference in interest rates. So if the US Dollar pays 0.25% and the Yuan offers 5% for example, you borrow Dollars and invest in Yuan and pocket the 4.75% difference.
Now, investors in currencies are permitted to use greater leverage than their counterparts in stocks or bonds. Whereas a stock investor might be permitted to leverage up at 20 to 1, (meaning he or she can borrow $20 for every $1 in capital in his or her account), currency investors can leverage in excess of 100 to 1 or even 300 to 1…
Now a carry trade only works when the currency you are borrowing in remains weak. As soon as it begins to strengthen, you profits not only evaporate but you can end up deep in the red (remember you’ve borrowed $100 for every $1 you have in capital).
Globally the US Dollar carry trade is north of $9 trillion: larger than the economies of Japan and Germany combined. And it began to blow up in July of 2014.
Now, a critical theme that investors need to understand is that stocks are ALWAYS the LAST asset class to adjust to major changes in the financial system. The currency markets ALWAYS react first. It is only after the changes become enormous that stocks finally “get it.”
Consider the Asia Crisis of 1997. Thailand devalued the Baht on July 2, 1997. However it was not until August that the Thai stock market began to react. And it took the rest of the year for Thai stocks to really “get it.”
The reasons for this are that:
1) The currency market is much larger and more liquid that bonds or stocks and so reacts more quickly to changes in the global economy.
2) It takes time for currency moves to begin to affect profits and profit margins, which affect stock prices.
3) Of major asset classes, stocks have the largest percentage of individual or retail investors who are less likely to be aware of changes occurring in the financial system.
The bottom line is that when currencies begin to blow up it takes time for the rest of the financial world to catch on. This is particularly true for stocks.
With that in mind, consider that the global US Dollar carry trade began to blow up back in July 2014. While most commentators focused on the impact this had on Oil, the REAL damage was done in the emerging market currency space.
Below is a chart showing the US Dollar/ Chilean Peso (black), US Dollar/ Brazilian Real (blue), US Dollar/ Mexican Peso (red), US Dollar/ South African Rand (red), and US Dollar/ Singapore Dollar (pink) currency pairs.
As you can see, between the middle of 2014 and today, ALL of these pairs have seen price swings ranging in size from 16% to 26%.
These are ENORMOUS movements for currencies. Imagine losing 25% of your purchasing power in the span of a single year. This ONLY happens when the financial system is under incredible duress.
Indeed, across the board, Emerging Market currencies are collapsing against the US Dollar, falling to the lowest levels since 2001!
Many investors were not aware of this level of distress because they focus on stocks. However, the US stock market finally began to “get it” in August 2015.
This is not over by any means. As I mentioned before, the US Dollar carry trade is over $9 trillion in size. This is larger than the economies of Germany and Japan combined.
The worst is yet to come and smart investors are preparing now, BEFORE it hits.
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