With so much commentary having been already written about Alistair Darling’s disappointing Pre Budget Report lets look at something which may have a real impact on the global economy and markets.

In recent issues we have looked at the dichotomy between positive market behaviour and the problems in key economies. Put simply markets seem to be discounting an outcome that seems improbable.

So if the market is not reflecting the economic reality what is it doing? We are increasingly of the view that in addition to the massive liquidity that has been injected into financial markets there has been one key story behind stock market strength and that is the dollar carry trade.

This is selling (effectively borrowing in) the dollar, which is cheap as the US base rate is basically at zero, while buying higher yielding riskier assets with the proceeds. This trade has enjoyed an additional benefit in that the selling pressure forces the dollar lower while the buying drives risk assets higher. This enhances the profit on both sides of the trade. The net effect of this can be shown on the chart below which compares the DXY index (which reflects the dollars level against a basket of six currencies, dominated by the Euro) with the S&P 500 US share index over the last two years.

The top line shows the strength of the dollar and you can see a significant inverse correlation to the strength of the stock market shown below. The weaker the dollar the stronger the stock market and vice versa.

Odd isn’t it, the weaker dollar should signify worries about economic disappointment, while the strong equity markets should indicate belief in recovery. So it seems that stock markets may have been going up, not because investors truly believe the economic environment has improved, but because it is the trade that has had all the momentum. But what happens when reality reasserts itself? Well that may be happening now.

Over recent days we have seen the Dubai crisis blow up, we have seen Greek government debt downgraded, while the Irish government has passed an unprecedented austerity budget to maintain confidence among bond investors. Furthermore Moody’s is now the second credit rating agency to suggest that UK debt will be downgraded, while Japan’s stellar third quarter growth recovery of 4.8% was adjusted to just 1.3% (annualised).  In this environment the US doesn’t look so bad, the dollar is looking oversold and the chart below shows how it appears to be breaking out of its trend.

If this breakout continues (despite Ben Bernanke desperately trying to talk down US prospects to keep the dollar weak) it will rapidly begin to undermine the logic of the carry trade as currency gains will be eroded, leading traders to take profits in risk assets, raising funds to close down (repay) their dollar positions. This could lead to some rapid corrections and although stock markets have shown mixed results a number of key commodities have shown sharp reversals in recent days.

If this scenario seems a little tenuous then the final chart, comparing the dollar/Yen exchange rate against the S&P 500, my help explain the concern. Until the middle of 2007 the Yen carry trade was the big news, with Japanese interest rates already pinned to around zero, compared to 4%-6% elsewhere. Hence traders borrowed in Yen to buy risk assets, in this case US stocks. Again the borrowed currency fell so again investors benefitted from both asset price appreciation and favourable currency movement. Once the carry trade came off in the summer of 2007 and the Yen began to appreciate traders scrambled to unwind their positions and the correlation to S&P 500 is clear.

As the credit crunch began around this time there was more at work than just this one trade but it was one of a number of key imbalances that helped destabilise markets as the edifice of unsustainable excess began to collapse.

The current hope for the markets is that we have begun to see the needed rotation into higher quality stocks in recent weeks. If this heralds the return of longer term investors there is a chance markets can survive a flight of short term punters (sorry traders) but the risks remain high.

And finally…..

Software Development Cycle

Software doesn't just appear on the shelves by magic. That program shrink-wrapped inside the box along with the indecipherable manual and 12-paragraph disclaimer notice actually came to you by way of an elaborate path, through the most rigid quality control on the planet. Here, shared for the first time with the general public, are the inside details of the program development cycle.

1. Programmer produces code he believes is bug-free.
2. Product is tested. 20 bugs are found.
3. Programmer fixes 10 of the bugs and explains to the testing department that the other 10 aren't really bugs.
4. Testing department finds that five of the fixes didn't work and discovers 15 new bugs.
5. See 3.
6. See 4.
7. See 5.
8. See 6.
9. See 7.
10. See 8.
11. Due to marketing pressure and an extremely premature product announcement based on an overly optimistic programming schedule, the product is released.
12. Users find 137 new bugs.
13. Original programmer, having cashed his royalty check, is nowhere to be found.
14. Newly-assembled programming team fixes almost all of the 137 bugs, but introduces 456 new ones.
15. Original programmer sends underpaid testing department a postcard from Fiji. Entire testing department quits.
16. Company is bought in a hostile takeover by competitor using profits from their latest release, which had 783 bugs.
17. New CEO is brought in by board of directors. He hires programmer to redo program from scratch.
18. Programmer produces code he believes is bug-free.

(It should be noted that there is absolutely no correlation between the use of this joke and a recent major software release. None whatsoever)