Does Carry Drive the Dow?

As trading becomes increasingly integrated, both across national borders and as well as asset classes, investors and traders in all financial markets have become acutely aware of the interrelationship between the carry trade and the equity markets. The easy explanation given by many of today?s analysts is that carry trade drives stock markets. However, the underlying truth is in fact more nuanced and complicated.

Studying the price action in both currencies and stocks over the past several decades we have discovered several interesting dynamics between the movement in the carry trade and the uptrend in stocks. While there is some correlation it is by no means uniform. Nevertheless, by having a deeper understanding of the price movements in both markers, traders should be able to better ascertain the rewards and the possible pitfalls that await them.
Carry Trade - It?s not Just the Yen
When most investors talk about the carry trade, they inevitably refer to the USDJPY pair which has been the dominant carry trade strategy over the past several years attracting billions of dollars of capital. Japan?s decade long struggle with deflation which at one point reduced interest rates in the country to 0% has made the yen the perennial favorite funding currency against high yielders such as the British pound, the Australian and New Zealand dollars and of course the greenback. However, using USDJPY as a proxy for the carry trade greatly limits our analysis and skews the historical record. Note, that as recently as 2004 USD short term rates were 1% and the greenback itself was used as the funding currency rather than as the high yielder in many carry strategies.
In order to more accurately measure the price action of the carry trade we created a rolling carry trade basket composed of top three high yielding currencies against the bottom three low yielding currencies updated daily over the past seventeen years using 3 month LIBOR rates for each country. For our universe of currencies we used the majors (EURUSD, USDJPY,GBPUSD, USDCHF) as well as the commodity dollars (USDCAD, AUDUSD, NZDUSD).
The difference is startling. Note in Figure 1 how over the past several years USDJPY trade was actually range bound, subject to a multitude of factors from political risk events to compression and then expansion of interest rates between US and Japan. However, the carry trade basket equity curve displays a near perfect uptrend during the same period, indicating that the over that time horizon the strategy was consistently profitable.

Carry Trade and the Dow Correlation on Direction But Not Time
Looking at the relationship of the carry trade and the equity markets we discover some interesting dynamics as well. In order to make our analysis more manageable we?ve divided our lookback period into 2 sections - 1990-2000 and the more recent activity between 2000-2007. As we can see in Figure 2 the directional correlation between the carry trade and the Dow was a remarkable 0.95 as both investments rose in near perfect unison. However, when we analyze the correlation in the monthly price changes it drops markedly to 0.12 suggesting that while the overall trend is the same, the two indicies move quite differently. One way to think about this is to imagine a highway with two cars. Both automobiles are going in the same direction, but at different speeds. Sometimes one automobile is ahead and sometime the other automobile leads, as the first car slows down and vice versa.

During the 2000-2007 period the correlation between carry trade and the Dow degrades but nevertheless remains significant at 0.49. Note however, that just as in the 1990-2000 sample the monthly returns show little correlation at 0.24.

What Can Learn From Our Analysis?
It is quite clear that despite the strong correlation in long term trend, carry trade returns deviate substantially from equity market returns in the near term and traders should not necessarily assume that a change of direction in one market will lead to an instantaneous change in the other. Nevertheless, one only needs to look carefully at the charts to see that the carry trade movements do foreshadow movements in equities on an intermediate time scale. The idea makes sense. In its purest form the carry trade is essentially the never ending hunt for yield by global investors. When the carry trade performs well, it creates excess returns not only in the form of higher yields but in sometimes very substantial capital appreciation as well. These excess returns, generate massive amounts of capital which seeks more speculative returns and often finds its way to the equity market. In short money begets money which in turn fuels equities - a dynamic that has been abundantly evident over the past few months as the Dow reached record highs.
Both carry trade investors and equity investors have benefited tremendously from this mutually advantageous arrangement. This positive cycle has been further reinforced by record low volatility levels as investors have demanded less and less yield for an increasing amount of risk. However, traders in both markets should be aware of the potential dangers ahead. Should risk aversion and high volatility return to the markets, both carry trade returns and equity prices will suffer badly. For the time being, both carry trade and equity strategies are performing well, as one in effect finances the other. But if global markets are suddenly faced with massive bout of credit contraction these strategies may no longer work. For now, the slowdown in US housing market remains contained, but should the level of foreclosures in residential properties rise markedly, it could create just the type of credit contraction event that would hurt both strategies. Presently, however, global interest rates from Eurozone to UK to Australia and New Zealand and even Japan appear to be headed higher and neither the carry trade nor the equity markets are feeling any pain.