The Scariest Thing On Wall Street

¹²The Scariest Thing On Wall Street

By Jeff Clark | November 3, 2009

The ability to short dollars at virtually zero cost and then use the proceeds to buy other assets— like stocks, bonds, gold, and oil— has been a winning trade since the dollar peaked and the stock market bottomed back in March [[or April for 2010: normxxx]]. But now that trade is getting a little long in the tooth. You see, never before has the dollar been so despised as a currency [[except after QE1 last year: normxxx]]. It seems as though everyone is riding the "dollar is doomed" bandwagon. And this rampant dollar pessimism is occurring at a time when everyone is falling in love with stocks and commodities.

So we have a beaten-down currency being used to prop up other assets, which have already inflated considerably in just a few [weeks]. It's the exact opposite of what we had in March [[or April for 2010: normxxx]], when everyone was selling assets and rushing toward the safety of [USTs]. Have economic conditions really changed so much?

Things have improved somewhat. We are no longer on the brink of a financial meltdown, and there are signs of modest growth in the U.S. economy. [[Actually, in this year 2010, economic conditions here seem to have plateaued at best.: normxxx]]

But income-tax receipts are still declining, foreclosures are still on the rise, banks still haven't written down the value of bad loans, [[— including the value of possibly non-existent mortgages— unemployment seems stuck at 9.6%, small business outlook is falling, : normxxx]] and the consumer is still not spending. In other words, we still don't have the economic foundation to support rapidly rising asset prices. The gains of the past … month are principally the result of a falling dollar causing asset price inflation. Traders who have been short the dollar and long riskier assets have profited on both sides as the carry trade bungee cord has stretched far beyond its normal limits.

What happens when the bungee cord snaps back? What happens when the carry trade begins to unwind? If you've ever been on the wrong side of a short squeeze, then you know the answer. When heavily shorted stocks stop falling, traders step in to cover their positions. The ensuing rallies can be spectacular.

Consider the case of Fannie Mae (FNM). FNM is a worthless company, and the stock really has no equity value behind it. But FNM rallied more than 140% in just four days back in August, 2009 when short sellers panicked and rushed to cover their shares. Imagine that those traders used FNM short-sale proceeds to buy other stocks. And then they had to sell those other stocks in order to buy back FNM shares.

Not only would they have gotten crushed when trying to cover their short FNM positions. But they'd also suffer as their other stocks cascaded lower amidst a flurry of sell orders. That is the risk of an unwinding carry trade. As soon as there's a sustained uptick in the dollar, traders will need to sell their other assets in order to buy back their short dollar positions.

Given the overwhelming short interest in the dollar, a small rally in the greenback could lead to a truly frightening correction in stocks.

Best regards and good trading,

Jeff Clark