Stocks Are Going Down – The Aussie Dollar Proves It

by John Jagerson | May 25, 2012 1:44 pm

Stocks Are Going Down – The Aussie Dollar Proves It

If investors around the world were to be compared to dinner guests, an attentive host would tell you, they are simply full up. They no longer have an appetite for risk, and no, they don’t even have room for a little after-dinner kiwi plate, thank you very much.

Recently, the U.S. dollar has strengthened against all major currencies except the yen. Even high-yielding champs like the New Zealand dollar (also known as the “Kiwi”) and the Australian dollar (A.K.A. the “Aussie”) have weakened significantly since the decline started to pick up steam in May.

The divergence is a strong indication that, globally, investors are seeking safety over risk.

Perhaps the most conclusive evidence can be found in the performance of the Aussie-yen pair, one of the most popular carry trades in the financial markets. A carry trade is constructed by buying a high-yielding asset and simultaneously shorting a low-yielding asset. Depending on market conditions, this can be a very productive strategy, but when traders get nervous about risk, they tend to exit quickly.

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Since the Australian dollar pays the most interest (3.75%) and the yen the least (0.1%), this currency pair represents the simplest way for banks and institutions to earn overnight interest income in the form of a carry trade. This pair makes an excellent gauge for institutional investor attitudes toward risk. Even better, the pair is highly correlated with the U.S. stock market.

The higher the price of this pair, the more institutions vote to expose their money to risk in return for the opportunity of earning interest. Lately, both this pair and domestic markets have watched holdings recede from risk assets into cash — that is to say, U.S. dollars. They experienced an even larger bearish divergence last March and April, and look how that turned out.

One could speculate that there is serious credit risk as a result of these signals, but it is more likely to be outdone by worries regarding Greece and rising yields in Spain. If these worries fade (a big “if”), risk-averse investors could change their minds and reverse the market’s course; however, that is not likely to happen quickly. We would expect to see improving market conditions show up in the AUD/JPY carry trade as well. So far, that is not the case, but it’s a good risk barometer to watch.

Given the risk aversion in the market and that traders seem to be heading for the exits, overall, in SlingShot Trader, our stance is bearish at the moment, and we’re using puts to profit from downside momentum.

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