Between March and the start of December 2009, the U.S. dollar fell 17%. Why the drop? With interest rates near zero the dollar is being used in the so called "carry trade." The carry trade is used when investors and traders sell US dollars and buy riskier, higher yielding securities.

The result of the falling dollar has sparked a rally in commodities and stocks. Now, if traders unwind large chunks of their dollar trades, the markets can sell off. The rebound in world economies after the meltdown is based upon rallies in commodities and stocks. Yes, this does create inflation but the Fed is more worried about deflation than inflation. The Fed is willing to accept a measure of inflation to jump start the economy.

It's Monday morning. Looking at the boards, the dollar is weaker and gold climbs to another record high. Spot gold in London traded at $1,133.07 per ounce. The December gold futures contract traded at $1,133.50 per ounce.

Again today, the dollar traded down, with the December dollar contract trading at 75.105, down 32 (prices as of 8:39 EDT). The other precious metals followed gold higher. December silver traded at $17.815 per ounce up 43.5 cents. Platinum was at $1,428.90 per ounce, up $41.20. Palladium traded at $365.15, up $8.40

The carry trade is back in vogue with hedge funds and large institutional traders.

First of all, what is the "carry trade?" It is a very simple trade. Traders buy a currency, such as the yen, in which interest rates are near zero and buy a currency in which rates are higher, and they pocket the difference.

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."

The dollar rose early Monday against the euro, pound and yen, but for all the wrong reasons -- a belief that more banks in the U.K. and Europe will face pressure and Europe's economy will slow further.

The dollar rose almost 2 cents versus the euro to $1.4367 and 3 cents versus the British pound to $1.8035. The dollar also rose about one-quarter yen to 106.25 versus the Japan's yen.

Currency Trader Andrew Resnick said the dollar's merely modest rise against the yen is the telling indicator in this currency market. Typically, a dollar rally would spark a large move up versus the yen as well, not just a minor increase. The fact that it hasn't indicates that institutional investors are paring-back their carry trades on concern the U.S. Congress' $700 bailout / rescue bill may not be enough to check the financial crisis, leading to slower growth in Europe, he said.

In a carry trade, investors, especially institutional investors, borrow funds in a country with a low interest rate (or borrowing cost) such as Japan [the yen], and buy assets in a country where returns are higher. The investment can take many forms including stocks, bonds, funds, or even the higher-interest currency itself, such as the British pound.

A flight to the dollar? Amid the United States' worst financial crisis in more than 20 years, perhaps since The Great Depression of the 1930s? It seems almost paradoxical, but that's the reality. So far. Stay tuned, an economist says.

The dollar has lost ground versus the world's other major currencies, amid this latest round of write-offs, bankruptcies and mortgage-asset-related stress on Wall Street, but the greenback has not plunged. In fact, the dollar is off its lows registered early Monday.

In early Tuesday trading, the dollar rose about a half-cent versus the euro to $1.4198, 1.5 cents versus the British pound to $1.7854, and a half-cent versus the Swiss franc to $1.1101. However, the dollar fell about 1 yen to 103.68 versus Japan's yen.

Themes: flight to quality, de-leveraging

Economist David H. Wang told BloggingStocks Tuesday the dollar's recent track displays two tendencies: a flight to quality and an unwinding of the carry trade -- i.e. a global de-leveraging.

"Although the U.S. Government and taxpayers are likely to spend more to deal with this financial crisis, and that implies more dollars in supply and inflation, institutional investors fear a decline or collapse in stock markets around the world, and are piling into the dollar," Wang said. "That is offsetting the dollar-weakening-effect of more U.S. Government spending. Essentially, it is flight to quality, so far."

Japan's yen resumed its rise against higher-interest currencies Thursday, suggesting that the prospect of additional credit market losses continues to lower investors' confidence in global growth and performing assets.

The yen rose as institutional investors continued to decrease their use of the carry trade.

In a carry trade, investors, especially institutional investors, borrow funds in a country with a low interest rate (or borrowing cost) and buy assets in a country where returns are higher. The investment can take many forms, including stocks, bonds, funds, or even the higher-interest currency itself.

The yen strengthened about 1.6 yen to 160.71 versus euro, about 3 yen to 201.95 versus the British pound, and about 1 yen to 108.20 versus the dollar.

Another big mortgage write-off ahead?

Currency trader Andrew Resnick told BloggingStocks Thursday sentiment is building in the foreign exchange and other markets that there will be "another, major housing-related write-off by a bank or series of banks in the U.S. or U.K, or possibly Fannie Mae (NYSE: FNM) or Freddie Mac (NYSE: FRE) problems."

Some market signals are well-known and easily understood. Others are arcane and more-complex, but just as telling.

There's mounting evidence that the "carry trade" is ending, or that at least institutional investors are decreasing their use of it as an investment tactic.

In a carry trade, investors, especially institutional investors, borrow funds in a country with a low interest rate (or borrowing cost) and buy assets in a country where returns are higher. The investment can take many forms, including stocks, bonds, funds, or even the higher-interest currency itself.

Carry trade: A growth confidence indicator

Now, investors/readers may legitimately ask, Why is it important to know what's happening to the carry trade?

Economist Peter Dawson told BloggingStocks that it's important to monitor carry trade flows and data because it's one indicator of investor confidence in a market's ability to produce a return on equity, and by extension, in its economy to grow.

In other words, the carry trade abounds when investors are confident; it wanes when they're not, he said.

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.