USD: The Return of Carry Trades Reversal

In the early 2000s, investors attributed market corrections to a powerful external force known as carry trade reversal. Back then, when we talked about carry trades, we were referring to JPY carry trades. That's because JPY carry trades was the only carry trades in town.

A carry trade operates on the simple idea that investors should borrow fund in a currency that has low interest rate & use the fund to invest in assets that can generate higher return. Carry trade reversal happens when either one of these 2 things happens: the funding currency appreciates or interest rate of the currency rises. Today, the idea of unconventional monetary policies is no longer a stranger to central bankers and the world is now flushed with money due to multiple quantitative easings. As a result, carry trades is no longer an exclusive Japanese export. In fact, the dominant carry trades for the past 5 years had been the USD carry trades- thanks to 3 rounds of quantitative easing by the US Fed.

If you get into a carry trade (say, USD), you would be borrowing a USD loan and then using the proceed to invest in an asset (say, Malaysian stocks). Essentially, you would be shorting USD and long Malaysian stocks. Immediately, you can see the problem; Malaysian stocks had lost ground but USD has risen substantially. The rise of USD has been advertised for sometimes now; first, the slow rollback of the amount of assets buying by US Fed and soon, the increase in interest rate (expected in early 2016). The tightening of the US monetary policies may come at a time when quantitative easing by other countries (such as EU & Japan) may be peaking.

To make matters worse, USD Index has broken above its long-term downtrend line, RR. This means that USD Index is likely to go into a long-term uptrend. Where will this uptrend reach is anyone's guess! It may test the 2002 high of 120 or it might go ballistic and revisit its 1986 high at 160!! That means it may see a rise of a painfully 20% to a whopping 60%! If either one of these comes to pass, asset value worldwide will be in for a big drop!

Thus, we can see blue chip stocks grinding lower as foreign funds are still selling. The only game in town are second & third liners stocks, where the sellers and buyers are Ali, Ah Chong & Muthu and not Peter, Paul & Mary. 

   
Chart: USD Index's monthly chart as at November 2015 (Source: Stockcharts.com)