Risk assets fall as carry trade unwinds

The QE sugar daddy is gone and with it seems to be departing the never-ending barrage of USD-carried yield chasing that characterized post-March 2009.

The Dollar Index traded up 0.75% to 80.15 today, breaking the 79.70 resistance level. We expect the USD to continue marching higher as demand from real economy deleveraging outstrips excess USD supply (both QE liquidity and the Fed’s dollar liquidity swaps are all but gone). The pervasiveness of the dollar carry trade will amplify the USD spike, as shorts get squeezed, forcing a positive-feedback demand loop. Dollar-funded carry trades across various forex pairs were sharply unwound today.

Dollar index



Meanwhile, sovereign debt fears continue to heighten. Greece and Portugal CDS spreads are not the only ones widening, either, as contagion risk spreads across the eurozone, tanking the euro. German 5yr CDS traded up to 55/60 today, as Greek and Portuguese default risk becomes increasingly priced into bailout-gifting bunds. United States 5yr CDS shot up to 55/60, as well today. From an earlier post:

The long bond has seen dramatically rising yields since January as the yield curve steepens due to rising inflationary concerns and deteriorating sovereign credit risk (USA CDS was one of the worst-performing sovereign names in Q4 2009, widening 13.5bps or about 66%). However, the 30yr yield seems to hit an important long-term resistance level at 475bps and appears ready to go back down. Since September, the 30yr has been defined by a rising channel; once that breaks, long bond yields could sell back off, with the 30yr targeting the 420bps support level, and if that breaks the 390bps support level, both of which are significant S/R zones. With risk aversion creeping back into the market (and the Treasury’s desperate funding crisis it may try to resolve by the Fed draining liquidity and/or engineering a risk asset selloff), US sovereign fixed-income should find some inflows from risk assets. Though we suspect the back-end of the curve to not see a lot of inflows on a relative basis, hedging that steepener trade on the short/intermediate term may be prudent.

Credit markets showed risk aversion en masse today, as IG witnessed a 61:1 widener-tightener ratio today, en route to its close at 99.75bps (though it touched triple digits earlier today). We expect continued deterioration in credit (as well as equity) and are watching for non-sovereign spread widening to complement the sovereign widening that’s been occurring for about 3-4 months now.

We aren’t the only ones bearish on credit going forward, either, as BlueMountain Capital announced a liquidation of their debt fund incepted at the depths of the credit crisis last March:

“We’ve captured most of the big opportunity,” BlueMountain co-founder Stephen Siderow, 42, said. “It isn’t going to happen again anytime soon and that’s why we urged our clients to move on.” They’re reinvesting in other credit funds of the $4 billion money manager that aren’t dependent on markets rising, he said.

BlueMountain last month returned money to investors from a $100 million two-year loan fund that gained 34 percent since its inception in March. Silverback Asset Management LLC is giving money back from its $210 million two-year convertible-bond fund, the firm said. Highland Capital Management LP said it liquidated a November 2008 fund that gained 138 percent before fees by investing in collateralized loan obligations.

Hedge funds and money managers are cashing out after assets from junk bonds to convertible debt had record gains last year, following unprecedented losses in the wake of bankruptcy of Lehman Brothers Holdings Inc. in September 2008. Debt markets soared in 2009 as central banks lowered interest rates to near zero and governments globally sought to avert the failure of the world’s largest financial institutions with capital injections and lending guarantees.

To put it simply:

“The easy money is over,” said Nexar Capital’s Attias.

Indeed it is, and Moody’s issued concern over the sustainability of America’s AAA rating today.

Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating.

But the USA isn’t the only AAA-rated borrower facing deterioration in perceived credit risk. Berkshire Hathaway (BRK.A/BRK.B) was downgraded by Fitch to AA+ on potential derivatives losses.

Crude was down $3.84/bbl (5%) today, as the contango trade unwinds. From an earlier post:

Crude is still in its rising wedge and may break down soon. This would be very bullish for USD and bearish for other risk assets. The 200DMA is approaching and crude’s behavior around there should dictate its future direction. Also, the contango trade from early 2009 is now unwinding, as the promises for delivery from traders who picked up crude during early 2009 contango for Jan-Mar 2009 physical delivery come due. A recent WSJ article delved into this concern:

Contango has narrowed to around 40 cents a barrel, and “to cover your freight and other costs you need at least 90 cents,” said Torbjorn Kjus, an oil analyst at DnB NOR Markets.

The contango trade is 50c/bbl out of the money at current levels and consequently no demand from that thesis is existent right now. This has big implications for crude prices, as the contango trade isn’t rolled over. Much of the crude due for physical delivery from the contango trade’s origination is due in February and March, and experts are voicing concerns over a lack of demand for tankers as storage demand declines:

ICAP said there were currently 21 trading VLCCs offshore with some 43 million barrels of crude. Seven of these are expected to discharge in February and one more in March. So far, it appeared those discharged cargoes wouldn’t be replaced by new ones.

“I haven’t seen any fixtures for VLCC storage in the last two weeks,” said Simon Newman, ICAP’s senior tanker analyst. “That would imply that storage looks set to fall in the short term.”

Assuming there are no new fixtures, the amount of crude in storage could sink to 27 million barrels by March, the lowest level since the current contango play began in late 2008.

More than 70% of oil’s rally from January 2009 came from January to July 2009, while it was in contango. The spread shifted to backwardation in July but soon reverted back into contango, though not nearly as steep as in the days of January 2009. The contango trade represents the demand behind oil’s rally from January to July 2009 and as that ended, the oil market flattened out (crude is back to July 2009 prices after its recent selloff). However, the big issue going forward is the imminent supply influx coming as the contango trade unwinds and key players are forced to provide their stored crude for physical delivery, rushing supply back into the market. And with such a tight contango and a net-negative profit from origination for the contango trade at current levels, the contango trade won’t be rolled over and what was previously demand will come due as supply.

The rising wedge mentioned above is now breaking down, signaling the unwind is at hand. Expect falling oil prices.


Meanwhile, even gold found selling today, exemplifying just how pervasive the dollar carry trade really is, as it broke below its descending triangle support line that we’ve been highlighting. Additionally, silver broke down below an important technical level, as well. We expect the gold:silver ratio to start rising once again on liquidity risks.



In a recent post about Amazon (AMZN), we noted:

Amazon’s stock has more than tripled from its lows, its EV/EBITDA is currently at 43.6x, and its P/E at 68.79. What drove this (and every other) stock up in 2009 was a combination of onetime bank injections (via AIG CDS unwinds) catalyzing a negative convexity dynamic hedging-driven short covering rally and the combined effects of QE liquidity and the USD-funded carry trade.

Now, with QE liquidity dried and credit events flaring up left and right (Greece in crisis, sovereign CDS breaking out, CRE defaults all over the news, and the housing double-dip manifesting), it’s time to look toward the exits.

We continue trading this thesis, as the positive-feedback demand becomes supply. And in regards to Amazon, it appears ready to break down below its 116 support level. We expect the October 2009 earnings gap to be filled and for this stock to trade back in double digits.


This seems to be the beginning of the reversal, and our portfolios are positioned for it. We expect vol expansion from here, as well as for high beta names to underperform. We also expect reactionary policy from the FRB, and a second iteration of QE and another round of liquidity swap extensions will bring back the short-USD (re/in)flation trade. Until then, we will stay long USD and short risk assets.

Some equity index charting:



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