When influential managers (e.g., large financial institutions, hedge funds, etc.) borrow low-yielding assets to invest in higher-appreciating, higher-yielding ones, they are engaging in a speculative art. What is the nature of the artwork here in 2014? Borrow as much yen and euro at negligible rates as possible to finance the acquisition of U.S. stocks and U.S. government bonds.
The “carry trade” works as a mechanism for buying U.S. stocks as long as the U.S. Federal Reserve remains committed to its zero percent rate policy and foreign central aim toward even larger-scale stimulative efforts (e.g., asset purchases, electronic currency creation, etc.). The carry trade also works for acquiring U.S. treasuries. If you can borrow the yen and the euro for a song, why wouldn’t you purchase dollar-denominated government debt that yields more than comparable Japanese government bonds or German bunds?
Of course, retail investors do not need to use leverage to pick up the assets that benefit from carry trading. ETF enthusiasts may simply purchase iShares S&P 500 (IVV) and Vanguard Long-Term Bond (BLV). Yet there’s a dark side to the precarious practice that can decimate your holdings just the same; that is, interconnecting forces can cause the process to reverse itself or “unwind.”
For instance, weak demand for oil around the world is a significant blow to Russia. Vladamir Putin relies heavily on oil revenue to service his country’s debt. If oil drops much further than the $70-$80 per barrel range, Russia might witness a debt crisis not unlike the sovereign debt crisis that Europe experienced in 2011. A spike in Russia’s debt yields could even lead to contagion across Europe. In other words, oil price deflation may seem like a great thing at the American gas pump, but it might cause a rapid exodus from U.S. stocks to pay back the borrowed yen and euro loans. Leverage works great until it’s time to “deleverage.”
It follows that few trends are as important right now as the relative strength of the energy sector. You can track its progress via the SPDR Select Sector Energy (XLE):S&P 500 price ratio. A rising ratio would likely indicate a belief in the stabilization of oil prices and/or a stabilization of global demand. Ongoing deterioration of this price ratio could be a nasty harbinger of “risk-off” selling in the broader equity markets.