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Unwinding Carry Trades and Unintended Consequences

The European Central Bank under the auspices of Mario Draghi has created a market destabilizing condition known as the euro carry trade. Mr. Draghi recently telegraphed to the markets a more aggressive attack on the value of the currency heading into the ECB meeting held on December 3rd. In fact, he went on record saying the ECB's imperative is to, "Do what we must to create inflation as quickly as possible." Because Draghi promised to destroy the euro at an even quicker pace than it was already falling, financial institutions front ran the ECB's increased bid for bonds and equities, sending these prices soaring in the weeks prior to the meeting.

The euro carry trade was in full swing. These banks and hedge funds also borrowed euros and bought higher-yielding dollar denominated assets. And, the falling euro/rising USD furthermore served as a green light to sell short most commodities, including precious metals.

A great example of how the euro carry trade works can be found in the market for U.S. Treasuries. In the weeks leading up to the December 3rd ECB meeting the U.S. Ten-year Note Yield fell from 2.88% on November 9th, all the way down to 2.26% on December 2nd, as traders sold euros and bid up Treasury prices. The trade was a double-win because Treasuries offered a higher yield than European bonds and was denominated in a rising currency. European traders could earn more income on their money while also benefitting from an improving currency translation.

But Mr. Draghi threw a wrench into this carry trade when traders became disappointed with the outcome of the meeting. The ECB did not increase the amount of monthly QE purchases as was highly anticipated. Draghi kept the level of monthly purchases at 60 billion euros. However, he did extend the program by 6 months and lowered the deposit rate by 10bps. This caused the euro to soar against most major currencies and sent carry trade speculators scrambling to sell bonds and stocks, and then sell dollars to cover their short euro position.

Of course, only in the twilight zone of today's fiat currency system would a cut in the deposit rate to -0.3% and an extension of QE by another 360 billion euros cause a currency to rise. But this illustrates how much the ECB overpromised on its efforts to create inflation. The markets simply became over extended in driving up the price of the dollar and the value of stocks and bonds.

Therefore, immediately after the ECB announcement the German DAX dropped 400 points (over 3.5%) and the US market reaction was volatile as well, with the Dow Jones shedding over 1.4% by the close, after falling over 300 points earlier in the day. US Treasuries also reacted violently, as 10-year Note prices plunged, sending the yield soaring higher by 7% on Thursday. The German 10-year Bund yield soared as high as 0.59%, from the low of 0.45%, and 2-year bond yields in Spain and Italy leapt from negative into positive territory.

This is just a taste of what is to come because the euro carry trade is just one small example of the huge distortions that have been created. The simple truth is all currencies, bonds and equities have all been so massively manipulated by the heavy hand of governments that there is now no easy escape. Last week's market action was merely the warmup act for the unintended and baleful consequences that will result from completely abandoning free markets to the control of global central planners.

 


Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

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