By Goh Eng Yeow
Markets Correspondent
engyeow1@sph.com.sg

 

THE buoyancy in Asian stock markets today reminds me of a law in physics — the Principle of Flotation — which every student would have studied during his secondary school education.

Essentially, it says that an object can float on water because there is an equivalent mass of fluid beneath it which is giving it support.

With equities levitating to levels last seen in 12 months ago, I wonder if there is a similar principle at work in the financial markets.

I spent yesterday writing an analysis on an esoteric subject —  US dollar carry trade. No many people understand what it is all about or how to track the size of the trade, but it is probably the biggest factor influencing the direction of the financial markets currently.

With US interest rates at almost zero per cent and the greenback sinking to almost all-time low against the Japanese yen and the euro, it is a no-brainer for any bright trader to borrow heavily in greenback to make big bets on other asset classes.

In doing so, he is betting that when he has to repay the greenback loan, the US dollar would have fallen sharply, and so the asset he has brought would be worth a lot more in greenback terms.

This has propelled the stock market here, as well as those elsewhere in Asia sharply higher, as cheap money floods the market and the resulting rising tide lifts all equities – quite literally.

The carry trade is also providing the fuel for the renewed spate of mergers and acquisitions.

Just watch Wall Street last night when the Dow shot up 123 points on a wave of M&A fever. When money becomes so cheap, chief executives start becoming empire builders again.

But apart from the equity investors who stand to make a killing from the galloping stock markets, why should anyone else bother about it?

A weakening greenback has consequences far beyond the equities markets.

As the Japanese have discovered to their horror, the switching out of yen into US dollar borrowings has caused their currency to surge to near record high levels, raising fears that their companies may be priced out of business altogether.

This is despite all the warning signals flagging red that it is in danger of falling into a deflation trap again because of falling demand, as people anticipate tougher times ahead and cut back on their spending.

For the rest of us, another fear looms – the spectre of run-away inflation if the prices of oil and other raw materials surge and cause an untenable rise in consumer prices.

So far, this has not happened. Because the US and Europe have been mired in recession, demand has been weak and there is more than ample supply of oil available, and this has dampened the pricing power of the producers.

But this sweet spot may not last forever.

Eventually, the supplies would have been used up, and there would be pressure to raise oil prices to compensate for the weakening dollar.

For investors, the best strategy going forward is to track the US dollar.

I expect regional markets to enjoy the sea of support provided by the US dollar carry trade, until the greenback strengthens and forces a un-winding of the carry trade.

Then it is time to get hell out of the market and stay in cash. It is worth recalling the violence which had accompanied earlier unwinding of the yen carry trades during the Asian financial crisis in 1997-98 and again during the recent global financial crisis,

How long will this rally last?

It is hard to tell, but bearings on the equities markets in the near future, in all likelihood, will come from the currency market.