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Market Intelligence: Unwinding of 'Carry Trade' Hits Stocks

Worries about the credit markets aren't the only reason investors are fleeing to the relative safety of Treasurys.

An unwinding of the so-called "carry trade"--a popular financing tool for hedge funds and other big investors--is accelerating the move away from risky assets.

In a carry trade, an investor borrows money in a country where interest rates are low--primarily Japan--and invests in other countries where the return is higher--such as U.S. stocks. The dollar's recent decline against the yen, however, has made this arrangement less lucrative, prompting more investors to "unwind," or sell the assets, to repay the yen loans.

That, in turn, boosts the yen even more and fuels the selling of stocks and non-Treasury debt.

The rush to Treasurys has pushed the yield on the 10-year note down to the 4.8% level. The "flight to quality" is also being spurred by weaker than expected economic data today, more reports of weak earnings for homebuilders and news yesterday of the extent of the problems Cerberus has had in selling debt tied to its buyout Chrysler.

Boris Schlossberg, senior currency strategist for Dailyfx.com in New York says the associated worries that credit problems could lead to a slower than expected U.S. economy has intensified an unwinding of the yen-carry trade.

Schlossberg says the unwinding of the carry trade has gained momentum in "fits and starts" in recent days, adding that the "carry trade topped out at about the same time the Dow reached 14,000."

"If you watch the Dow and the yen they've been moving tick for tick today," says Schlossberg. "It's only the yen that has appreciated substantially today against the dollar. The euro and the pound are pretty flat. The carry trade has financed much of the speculative activity we've seen and the unwinding we're seeing is all based on risk aversion."

Schlossberg says the 115 level of the Japanese yen could become a "very serious" magnet in the carry trade unwinding process, as it did in early March.

Volatility

As the stock market slides, the CBOE Volatility Index continues to surge to the point where it has surpassed the CBOE Nasdaq Market Volatility Index . IA Englander director of market strategy, Scott Fullman, says "that's a rare event". He says fear and risk aversion in the general market "related to the condition of financials and homebuilders has become so widespread that it has overtaken risk associated with Nasdaq names in technology and biotech".

Fullman also says there's another unusual market divergence. Among the nine SPDR Exchange Traded Funds that track the performance of S&P 500, the S&P Utilities SPDR is the biggest decliner - down by more than 3% even as Treasurys rally.

Fullman says "normally the utility stocks would benefit from declining bond yields, but you have to remember that utilities are closely tied to the financial sector."

Sam Stovall, the chief investment strategist at Standard and Poor's Equity Research says the selling is being spurred by guessing over the unknowns in the market. He says, "the worry is keyed into actual subprime problems, but what about Alt-A, second mortgage, LBO deals, corporate M&A. Will all that eventually lead to a credit crunch?"

Further dampening sentiment, a new report on the extent of mortgage defaults released by Moody's economist Mark Zandi predicts a national median house price drop of 9% by next summer. While Moody's doesn't see a resulting recession, it does predict that holders of mortgage backed securities could suffer losses of up to $125 billion.

The housing forecast comes as another Australian hedge fund has been caught up in the subprime mortgage fallout. Absolute Capital has told its investors that has suspended withdrawals from two funds until October due to a lack of liquidity in structured credit markets, according to Reuters.

Traders are also talking about the price of crude oil as West Texas Intermediate which vaulted past the $77 mark earlier today. Schork Report editor Stephen Schork says one way to look at the market is that supplies are plentiful enough to keep OPEC from further raising prices, which puts further upside pricing pressure into the market. Writes Schork this morning, "we think there is virtually no chance the cartel will ramp up output this quarter".

Analyst Action

Following Apple's stronger than expected earnings accompanied by its usual conservative guidance, analysts are reacting in mostly positively.

Deutsche Bank lifted its target to $200 a share saying it sees multiple drivers of earnings for the second half of this year. Caris and Company raised its target from $140 to $165. Needham called the quarter a ''blowout" and lifted its target to $170 from $135. UBS maintains a buy and upped its target from $160 to $175.

Following Chinese internet search company Baidu.com's earnings of 57 cents versus a consensus estimate of 44-cents, Citigroup has lifted its price target to $250 a share and upgraded the stock to a buy.

Merrill Lynch has been removed from the Conviction Buy List of Goldman Sachs which still maintains a Buy and a $108 price target.

Southwest Airlines gets a downgrade from Strong Buy to Buy from Matrix USA citing valuation.

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