USD Carry Trade: The 500-Pound Gorilla?    

• Encouraged by assurances from the US Fed that they are not about to abruptly remove the punch bowl from the excess liquidity-driven party in equities, commodities and high yield debt from March lows, US equities and commodities remain buoyant.
• The S&P 500 so far has lost but 6.5% from a recent 1,101.36 high, but has dipped below its 50 day moving average, and is looking at a 16.5% peak-to-trough correction if it pulls back to its 200 day moving average. Yet even this degree of correction however would still leave the market above bear market (20% or more correction).
• But the 500-pound gorilla in the room is the USD carry trade. This has investors very skittish about Fed QE and ZIRP exit strategies, as any unruly unwinding of this carry trade could be devastating for capital markets, if past unwindings of massive currency carry trades are any guide.
• Given the notorious track record of past unwindings in carry trades, the risk hedge of choice at present is gold, but this is becoming a very crowded trade, and the experience of 2008 is that gold also gets sold off during any liquidity squeezes caused by unruly carry trade unwinds.
• Despite "new normal" scenarios for the US and other developed economies, the IMF, World Bank and other observers have a rosy outlook for economy recovery in ex-Japan East Asia which is behind the clear outperformance of markets in the region to date. Further, GDP forecasts have recently been revised upward yet again.
• Generally, while the economic data continue to suggest that Japan's economy continues to claw its way back from one of the deepest recessions in the postwar period, Japan remains a major exception to the positive economic scenario for recovery in the East Asian.
• Hobbled by serious concerns about the newly installed DPJ's ability to contain Japan’s ballooning debt while executing a strategy to revive growth in Japan, Japanese stocks have effectively de-linked from the global rally in equity markets since August, and we don't see this gap being rectified any time soon, as foreign investors now think that investing in Japan has a high opportunity cost.

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