Watch the Dollar Carry Trade

Related Quotes

Symbol	Price	Change
UDN	26.94	0.00
UUP	23.49	0.00

{"s" : "udn,uup","k" : "c10,l10,p20,t10","o" : "","j" : ""}

The dollar carry trade appears to be back on with a vengeance as the weaker dollar continues to propel risk assets higher. Interesting, however, is that oil and gold are not enjoying the same strength as the stock market, which has been a persistent feature of Wall Street's recent rallies.

Carry trades, which allow traders to borrow cheaply in low-yielding currencies, give speculators like big hedge funds and prop trading desks at major Wall Street firms extra leverage to engage in ultra-low-cost speculation and reap rich rewards. In prior years, the Japanese yen was the currency of choice for such trades, but the dollar has now supplanted the yen as such a tool.

Carry trades do not come without risk, despite the low-cost nature of the transactions. An abrupt reversal in a currency can wipe out the gains and exacerbate the declines traders experience when a carry trade goes bad.

The carry trade continues to knock the bears back on their heels. Last week's stock market decline was coincident with a rebound in the U.S. dollar. And as I have remarked (and as UBS veteran Art Cashin has been saying for months), the dollar and stocks have had a near-perfect inverse correlation for the last six months.

I have for some time been a dollar bear (and happy to be one) for reasons I have already explained. It is interesting to note, however, that while the dollar is down around 7% year to date, the S&P 500 is up twice that amount. The power of the carry trade and associated leverage of using a low-yielding currency to amplify gains is quite enticing, to say the least.

Still, the carry trade is a phenomenon worth monitoring. A geopolitical event can turn the dollar higher while gold and oil rally on a flight to safety, a break with recent trends. The inverse correlation with stocks, however, would likely crack under those conditions as the dollar and other hard assets become havens and stocks are sacrificed until the smoke clears.

The market's ability to whipsaw the crowds has been startling to say the least. The S&P futures were down in overnight trading only to turn as the dollar resumed its downtrend, most acutely against the yen and euro, while strengthening quite noticeably against the British pound.

Interestingly, even as stocks strengthen, interest rates continue lower. The yield on the 10-year Treasury note has fallen all the way back to 3.3%! This defies expectation and explanation based on the 25 years of market history that I have witnessed unless we are entering (or re-entering) a period of benign disinflation.

That is difficult to believe given our recent experience with outright deflation. But it is a conundrum that is flies in the face of conventional economic wisdom.

A budget deficit of $1.58 trillion, a declining U.S. dollar, rising gold and oil prices and a yawning trade gap are supposed to drive interest rates sky-high ... and yet they are approaching levels not seen since May, when bond yields were rising from historic lows. Yields have traded between 2% in December 2008 and 4% in June 2009, and in between ever since.

This is a new conundrum for the bond markets and for policymakers. The Fed's presence in the bond market as a buyer of first resort, along with overseas buyers who have a record appetite for U.S. debt, smacks of a coordinated policy to hold U.S. interest rates down as a driver of global economic growth.

It's the only explanation that makes sense. The world can crave an alternative to the U.S. dollar, demand that U.S. deficits decline and lecture Washington about Wall Street's bad behavior. But it appears that driving markets higher and the dollar lower benefits all. The only question now is whether those dollars can effectively migrate from Wall Street to Main Street and cement this plan in place before a pre-emptive tightening by the Fed.

Know what you own: ETFs that track the U.S. dollar include. Other companies in the industry include PowerShares DB U.S. Dollar Bullish and PowerShares DB U.S. Dollar Bearish .