Asian stock markets took a pretty big hit during Monday's trading session after a rough-and-tumble Friday in the US. European shares are down as well, but traders are likely looking to see how Wall St opens in reaction to the news that Chuck Prince finally resigned as CEO of Citgroup. A break in the Dow below 13,500 would be bearish for US equities as a whole, but how this all will transfer through to carry trades remains to be seen as pairs like EURJPY and GBPJPY performed a bit better than global stock markets last week.

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Looks like the carry traders holding out through thick and thin. The severe drop in the Heng Sang couldn't get genuine confirmation from the US markets. Clearly, everyone is waiting for someone else to make the call on whether the next big risk aversion/appetite trend is underway. I'm thinking these CEO 'retirements' and steady stream of writedowns on mortgages will build momentum into the next selloff for yen crosses; but what will be the trigger this time around. It has become nearly impossible to tell what the next big trigger will be. Given disconnect between Asian and US market sentiment, I'm thinking it will be a big disruption during European hours. Perhaps a UK or Europe-specific bank that has to mark thousands of euros or pounds worth of writeoffs.

One of the key drivers of the carry trade has been overall risk sentiment, and one of the best measurements of risk sentiment is the spread between market rates and the equivalent rate on the risk-free government rate.

I personally like to look at the closely-followed spread between the 3m LIBOR (also referred to as Eurodollar rate due to naming conventions for interest rate futures) and the 3m Treasury bills rate. Why? The chart below says 1000 words. We see that the carry trade performance has closely tracked the moves in the Treasury-Eurodollar rate in recent months. That being said, it seems as though the spread between the risk-free and the market rate continues to compress--a bullish sign for the broader carry trade. I remain moderately bullish on the overall carry trade strategy.

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Follow me on this for a second.

The key component in creating inflation is essentially too much money chasing too little goods. That's the textbook definition, anyway. I would argue that, in a global economy, the rate setting of individual central banks have less and less effect to counter price pressures. That is, when the ECB runs around screaming about prices being too high, they threaten top raise rates. But what does the ECB raising rates actually do for them?

It raises the Euro through speculator buying, based on the belief that as rates rise, the interest of instruments denominated in Euro go up, and that the higher the Euro, the more defense the EZ has against inflation. Is that actually true?

I don't think so. For the more the Euro goes up and the dollar goes down, the more commodities, based in dollar currency, go up with it. It's a reinforcing circle that cannot be stopped by the European Central bank. Even if the Fed were to raise rates aggressively, it still would not limit free money. In order to eliminate or seriously damper free money in this global economy, the source of the financing needs to be attacked. In this case, the Japanese Yen.

So I argue that until the BoJ decides to set off on a series of interest rate hikes, there is absolutely nothing that will stop the "too much money chasing too few assets" out there. So the carry trade will continue to live on, dented here and there by risk, but never truly out of it until the source of free money (the yen) is adjusted.

Yeah, it's easy to agree on this front. A BoJ tightening cycle could easily undermine strong demand for yen-funded carry trades. But given overall uncertainty on global--and subsequently Japanese--economic growth, I think the central bank is very unlikely to take rates considerably higher anytime in the next couple months to a year.

Fukui seems to be warning markets lately that this speculation has to stop. His words.

Interesting points. Your analysis aligns itself to certain schools of economic thought, but I can see your argument. Of course, money growth in Japan makes up only a fraction of what is seen in the rest of the developing and industrialized world.

I can see another means for excess monies to quickly disappear: consumer debt in the US and UK suddenly collapse. Both nation's have seen spending on credit soar to record levels. Should the recent losses reported in the major banks or a rise in real lending rates rise, the reserve ratio for major financial institutions may be boosted and the printing presses will quickly go silent.

Should something like this happen, the bid in the yen will return double quick as inflation cools and real lending rates in the high-yielding economies drop.

Let's take your point on credit a step further. I just read Terri's article in which she mentions the yield curve of all the major currencies. She notes that CAD, AUD and EUR are all inverting, CAD by far the largest change. The USD and CHF are steepening rather smartly.

Given that consumer spending is by far the engine of the economy (and I'd argue economies almost everywhere), what do the bond markets of these countries tell us about the future of their markets?

It would seem, if we were to believe the bond markets, the view of Canada's economic prospects in the future have suddenly grown quite dim. The same with the Euro Zone, albeit at a much lesser change. The steepening of the US and Swiss indicate that the tough times are now, and the future should allow a brighter move.

Am I reading this incorrectly?

I would not look at the 3m LIBOR versus 10-year government bond spread as very relevant to overall interest rate expectations--at least not on the time frame we care about.

I would prefer to look at the 3m LIBOR versus 2y LIBOR spread in terms of interest rate expectations for a given currency. Comparing market rates to government bond yields is less than ideal because risk premiums add to your market rate and subtract from your government yield. The 3m LIBOR versus T-bill spread I posted before is a perfect example of that.

I would argue that longer-term government bond yields have more to do with inflation expectations and risk premiums than actual growth prospects.

Not referring to interest rates, but in the probability of a recession.

Well, in terms of predicting a recession, economists have typically looked at the spread between government bond yields, short-dated (2-year) versus long-dated (10-year) to gauge the likelihood of an economic downturn. I'm sure most of us can remember how economists made a big deal out of the fact that the 2yr-10yr spread was actually inverted for much of 2006 and some of 2007, citing statistics that "every time this has happened we have had a recession". Well, that's great. But that tells us nothing about the timing or when we can expect a significant economic pullback.

More recently the yield curve has actually normalized and continues to steepen. By the same logic that economists previously cited to predict a recession, this is a theoretically good sign for longer-term growth expectations.

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Exactly what I was referring to. Now what does it say in the Euro, Cad, etc market? It's pointing to the odds of a recession "in the future", no?

The ratio of long to short positions in the USDJPY stands at 1.52 as nearly 60% of traders are long. Yesterday, the ratio was at 1.72 as 63% of open positions were long. In detail, long positions are 3.9% higher than yesterday and 17.8% stronger since last week. Short positions are 17.4% higher than yesterday and 0.5% weaker since last week. Open interest is 8.9% stronger than yesterday and 20.0% above its monthly average. The SSI is a contrarian indicator and signals more USDJPY losses.

Source: FXCM Dealing Desk

For historical data and the latest charts based on the SSI please visit http://www.dailyfx.com/story/strateg...903946044.html

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I've attached similar yield spread charts in the ZIP file below if you'd like to take a look. To answer your question, the only major yield curves that are currently inverted include the UK, Australian, and New Zealand 2-10yr spreads. Does this suggest that investors are flashing caution on a longer-term basis? Maybe. But we saw that the inverted US yield curve wasn't exactly the razor-sharp predictor of an oncoming recession.

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I appreciate the chart pulls, David. I'm trying to learn as much as I can about the bond market, and it'll take me time to digest it.