The dollar and yen surged Friday -- with the yen the clear winner head-to-head versus the dollar -- as traders and institutions added both currencies in a flight-to-safety on concern that all of the world's major economies will fall into a recession at the same time.

The dollar surged 3 cents versus the euro to $1.2642 and 6 cents versus the British pound to $1.5606.

The yen strengthened 4.7 yen to 92.64 versus the dollar and about 10 yen to 144.73 yen versus the British pound.

Institutions raise cash in dollars, yen

Currency Trader Andrew Resnick told BloggingStocks Friday, this morning's flight-to-safety is not solely due to economic fundamentals, which suggest slowing growth in the world's major economies, but also hedge fund / investment fund de-leveraging and closing out of losing stock positions.

"We're seeing many things happen at once, and that's producing these enormous moves. First, the carry trade [where traders borrow yen and invest it elsewhere] is unwinding. Leverage for investing purposes is declining as a trading strategy," Resnick said. "Second, major players are raising cash to cover redemptions, which is also causing stock markets globally to plunge."

"Third, we're seeing a re-pricing of risk to the higher, which is forcing some funds to raise even more cash, boosting the dollar," Resnick said. "Some of the moves are cash-necessary moves, but many are clearly panic-based, with traders exiting positions that have little chance of succeeding if the global economy continues to slow."

With the Japanese yen continuing to fall against the US dollar as well as higher yielding currencies such as the South African rand and the British pound, the question is whether the "carry-trade" is back on? If so, stocks may continue to rise.

What's the "carry trade"? It's an investment strategy with currencies, where investors borrow money in a currency with low borrowing costs (such as the yen) and then invest in higher yielding currencies (such as the rand or Australian dollar), earning the spread. If this trade is "back-on," then it shows that investors are more willing to take on some risk, boding well for a continued stock rally as well.

In a report on Bloomberg: "The currency weakened the most against the South African rand and the British pound, two favorites of so-called carry trades, as the cost of protecting bonds from default declined."

The report then spoke with a currency manager: "With stocks rising this much, it doesn't augur well for the yen," said Mitsuru Sahara, senior currency sales manager at Bank of Tokyo-Mitsubishi UFJ Ltd., a unit of Japan's second- biggest lender. "Calm is returning to financial markets, and that allows currency traders to focus on rate differentials. The Fed may not have to cut rates much further.''

Keep your eyes on the carry trade to see where the markets may be heading.

Aaron Katsman is the lead Portfolio Manager and Managing Director of America Israel Investment Associates, LLC. and Senior Editor of IsraelNewsletter.com. DISCLOSURE: Writer's fund has no position in any stock mentioned, as of 5/2/08

The secondary effects of the subprime fiasco are rippling through the market. High among the losers are those firms living off the carry trade, borrowing currency from countries such as Japan at low interest rates and investing that money at higher interest rates elsewhere.

The foundation for the carry trade is a non-volatile currency market, since a sudden rise in the value of the yen against the dollar, for example, can more than wipe out the profits to be made via the interest rate difference. The recent market, however, has been anything but non-volatile; the dollar has dropped from 124 yen in late June to just 114.398 last Friday.

According to Bloomberg.com, among the big losers in the carry trade is J. W. Henry & Co, whose financial and metals portfolio took a $122 million hit in July. While any losses to the owner of the Boston Red Sox is good news to Indians fans like me, investors with J. W. Henry have seen the assets of the firm shrink by 75% since November. The hedge fund of Campbell & Co. also suffered over a 10% loss in July from its $9 billion portfolio.

A Goldman Sachs index of implied volatility on currency options has risen to 6.03% from a record low in November of 5.54%. With the forecast calling for turbulence in the currency exchange market, the carry trade does not seem like a safe harbor for the risk-adverse to wait out the storm.