Literally days after MKTSTK highlighted the risks of the Carry Trade we get to see its unwinding in action:
Equity markets started the week on a down note, with the SPY losing $1.39 (0.67%) on the day. Stock futures were lower in the overnight session, but after the New York open stocks retraced much of the down move and it looked like it was going to be a normal day. Then, without fundamental provocation the equity markets began to sell off a little after midday. Someone desperately sold 6100 e-mini contracts and stock futures lead the charge lower along with the SPY. Stocks continued to move down after 1pm and were unable to close much off their lows.
Long dated US treasuries saw their prices rise as a result of the equity decline. As we highlighted last week, US stocks and bonds had reached a point of dangerous positive correlation. We are witnessing moves in the market very similar to those of late January 2014, when the SPY lost 6% in two weeks. Markets are showing their fear and bidding up TSY’s and VIX futures as a result.
The pain in the energy sector showed no signs of stopping today, with benchmark oil contracts reaching multi-year lows. USO closed below $24.00, a historic low for the ETF.
A classic feature of a carry trade induced correction is a sudden reversal in the dollar. Traders have been borrowing Euro and Yen, selling them to buy dollars, and buying the US stock market. As the stock market declines, carry traders have to rapidly reverse their positions, putting pressure on the exchange rates involved.
Keep a very close eye on the value of the dollar. Any dollar weakness, especially against the Yen. Any Yen strength will be a source of weakness for the US stock market, as carry traders suffer loses quickly as the dollar loses value. Declines in the stock market and the dollar will feed upon themselves as a the pain spreads amongst traders.