The Margin-Call Market Rout

THE DOG THAT DIDN'T BARK gave the clearest explanation of what drove down risk assets across the globe Thursday.

Of course, the crisis of European sovereign borrowers escalated, sending the cost of insuring the debt of the governments and banks in Greece, Spain and Portugal soaring.

And news that in the U.S. new claims for unemployment insurance jumped unexpectedly in the latest week served to put markets further on edge ahead of the anxiously awaited employment report for January due out Friday.

So, the Dow Jones Industrial Average managed to hold the 10,000 mark by the skin of its teeth as it lost 268 points, while the broad, large-cap market measured by the Standard & Poor's 500 plunged over 3%, a loss nearly equaled by the Nasdaq Composite. And the U.S. stock-market's capitalization was about $400 billion lighter by the end of the day, as measured by the Wilshire 5000.

Credit markets also were slammed as the cost to insure investment-grade corporate bonds saw their biggest increase in more than two years. Commodity markets were pummeled along with most currencies relative to the resurgent U.S. dollar and, tellingly, the Japanese yen.

Yet, most significant was the one asset that didn't respond as expected. It is historically the ultimate insurance policy against the collapse of financial assets and political upheavals, a store of wealth since ancient times. That is, of course, gold.

Not only did it fail to maintain its value during the market maelstrom Thursday, gold's price plunged nearly $50 an ounce, or almost 5%. That dumping of the precious metal -- whose only true function is as adornment and as a store of value -- indicates a scramble for liquidity.

By all indications, that rush was to unwind so-called carry trades, which consist of borrowing dollars to fund purchases of other, presumably higher-returning assets. And with U.S. interest rates near zero, the allure of the carry trade is well nigh irresistible.

That means carry traders effectively are short the dollars they borrowed to buy commodities, emerging-market stocks, junk bonds, which beckoned with higher-potential returns. When those positions start to go against the carry traders, the leverage turns painful.

As they scramble to unwind the positions, they not only dump those risk assets, they also have to cover what is effectively a short-dollar sale to pay off that liability. With so many carry traders all making for the exit, there's a squeeze, sending the dollar still higher and exacerbating the pain.

Even as the U.S. Dollar Index (DXY) -- a measure of the greenback against a basket of six currencies -- extended its rally by gaining 0.76% (to just short of 80, a key technical level), the Japanese yen rose even more strongly. That's important because the yen has been the other main funding currency in carry trades, so its rise also suggests a similar short-covering.

The exchange-traded fund that tracks the currency, the CurrencyShares Japanese Yen Trust (FXY), surged 2.35% on nearly triple the average volume. By contrast, the CurrencyShares Euro Trust (FXE), the ETF that tracks the common currency, plunged 1.1%, on similarly heavy turnover as investors fled.

To be sure, some of the buying of yen and dollars did represent some flight to safe harbors, most particularly U.S. Treasuries, where yields tumbled from eight basis points for the two-year note, to 0.80%, to 11 basis points for the rest of the coupon curve. The 10-year note yield ended at 3.59% while the 30-year long bond closed to 4.53%. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) soared 1.6% on nearly twice the average volume.

But, as noted, gold was throttled along with other risk assets, such as commodities, instead of serving its traditional role of insuring wealth against the vicissitudes of markets and politics.

The popular SPDR Gold Shares ETF (GLD) plunged 4% on nearly double the usual volume. Gold stocks fell even harder, with the Market Vectors Gold Miners ETF (GDX) losing 5.5% on heavy volume. Silver, meanwhile, got slammed even harder than the yellow metal, with the iShares Silver Trust (SLV) losing 6.4%.

Again, if Thursday's rout had been a mere flight to quality, precious metals would have been up, not down sharply. This pattern suggests a reprise of the near-meltdown of late 2008 and early 2009, which also saw the yen and dollar soar in the scramble to repay borrowings in those currencies, which was paid for by the dumping of risk assets, including the traditional store of value, gold.

As with subprime mortgages, the crisis in sovereign bonds in the periphery of euroland had been pooh-poohed as having limited relevance to the larger financial world. But Tim Backshall of Credit Derivatives Research pointed out in a research note Thursday that the sharp rise in the cost of insuring sovereign debt drove up credit costs for "everyone," notably U.S. corporates.

At the same time, the rise in private-sector borrowing costs and risks has meant a scaling back of actual and expected central-bank tightenings.

Thursday, the Reserve Bank of Australia, which was the first central bank to begin raising rates in this cycle, surprised the markets by opting not to snug further. That reflects the restraint on the export-dependent economy by the sharp rise in the Aussie dollar and the tightening of credit in China, the nation's biggest export customer.

And in the U.S., probabilities of a Federal Reserve rate hike were pared further Thursday. The federal-funds futures market priced in just a 25% probability of a hike to 0.5% from the current 0%-0.25% target rate by the Aug. 10 meeting of the Federal Open Market Committee, according to Dow Jones Newswires. At the turn of the year, fed-funds futures put a 78% probability to such a move by the June 22-23 FOMC meeting.

In the past month, concerns about sovereign debt have continued to mount while the heady optimism about the U.S. economy's supposed recovery has been tempered by a rebound in jobless claims and the reality check from the Massachusetts Senatorial special election.

As a result, the carry traders are getting carried out, yet again.