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Market Intelligence: Corporate Spreads and the Carry Trade

Investors are sure to keep one eye on the debt markets and the other on foreign exchange as a cycle of rising risk aversion in the U.S. spurs an unwiding of the Japanese yen carry trade, which in turn sucks money away from global stock markets.

"What's fascinating is this correction is triggered by the carry trade of people unwiding because of something related to subprime," says U.S. Global Investors chief executive officer Frank Holmes. "All of sudden the hedge funds do this unwinding and this creates a price volatility."

Speculators have been reversing carry trade positions, which had used the low-yielding Japanese currency as a cheap source of funds to buy higher-yielding assets from other foreign currencies to U.S. stocks.

Seijiro Takeshita, director at Mizuho International in London, explains that the unwinding of the carry trade positions has been driven by "risk-taking ability in the U.S. going down."

Takeshita says he initially expected that the yen would behave differently and decouple from the U.S. He says the Japanese "economy is progressing nicely. Earnings are just fine, valuation is good, but the U.S is coughing and we catch pneumonia."

He also says the weekend defeat of the Liberal Democratic Party in Upper House elections in the Japanese Diet may give the Bank of Japan more room to lift interest rates in mid-August. Takeshita sees at least an 80% chance for a quarter point Japanese rate hike. The deviation in rates between the U.S. and Japan could further enhance currency market volatility.

Art Cashin, director of floor operations at the New York Stock Exchange for UBS Financial says, "I’m a little concerned that people taking risk off and unwinding some of the carry trade can make the yen strong enough to force people to unwind the carry trade - to go from voluntary to involuntary unwinding."

Cashin is watching the 117.5 yen level as a possible trigger point for trouble in the stock market.

Credit spreads in the high yield corporate market continued to widen early Monday by more than 20 basis points. The LCDX, a Markit.com index of derivatives representing the cost of insuring high yield corporate loans against default, finished Friday at a lifetime low of 92 cents on the dollar as the spread widened by nearly 50 basis points in a single day.

All of this leaves investors guessing, according to Johnson Illington chairman Hugh Johnson.

"These changing credit market conditions will have an impact on the economy," he says. "What will be the extent of that impact? What investors said last week is that it will be substantial."

Johnson says investors will attempt to shift the focus back to the "world of economics from the world of lending which could bring some buyers back into the market, but I'm not optimistic."

Analyst Actions

Late Friday night, American Home Mortgage announced that it would delay payment of its dividend which was payable this past Friday. A variety of analysts have lowered their rating on the stock. RBC has downgraded to a Sector Perform from Outperform. JMP cut the stock from Marketperform to Underperform.

Based on valuation, Motorola got an upgrade JMP to Marketperform with a $17 target.

Jefferies reiterated Marriott as a top pick in lodging, saying a recent selloff has created a buying opportunity.

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