Air Coming Out of the Forex Market Bubble

Well any thought that maybe overnight markets would BTFD and take advantage of the sudden pullback in the carry trade assets has been washed away as our new index plunges to a new low – minus 3.3K. I swear we must have kicked this thing off at or very near the top of the market because since the beginning of the chaos in the Japanese markets it has been a series of big steps down for the yield currencies – or alternatively a big step up for the borrowed ones.

Major Contra-Indicators Causing Pause

Recent releases of data indicating retail investors at or nearly fully invested in the market combined with the high-water marks in the Michigan confidence survey have all but guaranteed a top has been hit in US markets. It remains to be seen how far the market correction will go but if Japanese equities are any indicator we could be in for a 15+% haircut in New York. All that remains now is a Barron’s cover story with the headline, “All Is Well” lol. Did I mention margin interest neared all-time highs in May?

How the Carry Trade Index Is a Proxy for Air in the Bubble

Anyone who has been around forex trading at all knows it is the shortest, largest path to leverage. The expanded buying power of leverage in forex markets acts as a giant high-pressure system which pushes currencies far and wide into all manner of assets – either directly or indirectly. Wherever their is a lower pressure asset (lower price for a unit of expected return) – eventually a margined dollar (or yen) will find it and bid up that asset. Bubbles expand wherever air (dollars, yen, or Swiss francs) can go. What happens next is at some point everyone is margined up to the max of their tolerance for risk (or ability to find returns) and the selling begins – that or some event triggers panic selling which very suddenly lets air out of one balloon – which in turn causes a rush of air out of all the balloons eventually. We seem to be at that point this week.

Is There Any Likelihood of a Stock Market Turnaround Soon?

My experience tells me that once highly leveraged investors get spooked it takes a high level of safety before margin levels peak again. This recent turn of events / markets in Japan is a contagion which has some work left to do. If my new G7 Carry Trade Index (here) is indicative of anything, it is saying that a lot of air has come out of the deepest, most liquid financial market (forex) in a short period of time… and based on overnight results no one is rushing to pump more air back in. I’ll leave you to ponder the significance of that.

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