Friday, December 19, 2008

Dollar Crushed

Mosaic of the Mind asked:

Why would there be such a reversal while the American markets have "rallied"?
My response (I'd love feedback):
When markets sold off / dollar rallied in Sept-Nov it was due in large part to levered investors (ie. hedge funds) that were forced to sell off their positions. The dollar has been used as a carry trade (investors borrowed cheaply in dollars then exchanged these dollars for the local currency of their investment).

One example is Russia, where many investors borrowed in dollars, exchanged for Rubles (hence Rubles had rallied) and invested in Russia. Then from Sept-Nov, ~$100 billion in "hot money" was pulled and these investors closed their dollars / ruble positions to close their dollar borrowings (Russia may actually be a bad example as their dependence on oil is causing magnificent problems now... but ignore them for this thought experiment).

One can assume that the majority of this unwind ended ~Nov. 20th (though I think this is just the first wave). Now that these trades are unwound and equity markets have rallied, there is no longer the need or demand to buy dollars to close such trades. Thus, the dollar has sold off after being overbought due to:
  • The end of this unwind
  • The incredibly low interest rates, which will likely stimulate another wave of carry trades
Get ready for additional waves / volatility as leverage continues to work its way through the system.

Click chart for larger image:

Source: Investment Postcards