Tuesday's Late Rally Had Nothing to Do With Optimism

The stock market had a wild day on Tuesday. After Monday's big drop, the market gained a little early on. Then, when the big news hit with the Federal Reserve's statement that afternoon, stocks initially retreated. The market was hoping for another dose of monetary stimulus or at least for the Fed to open the door future support. Instead, all they got was a language tweak, which asserted that interest rates would remain near zero through mid-2013. But then, in the last hour of trading, the market soared. What happened?

It would be tempting to think that the market thought a little bit harder about the Fed's statement and realized that its clarity might provide enough certainty to help stabilize the economy. But that's not the case. In fact, the massive rally had nothing to do with a sense of hope or optimism. Instead, it was entirely due to a technical strategy that big investors were making based on the Fed's apparent promise to keep interest rates low and steady for about two more years.

For a lucid explanation, let's go to David D. Moenning, a professional money manager writing for Business Insider. He says that a massive "dollar-carry trade" caused the market's strong finish:

To further explain, a "carry trade," in which a trader (of substantial size - think a big hedge fund, a Wall Street Bank, or sovereign fund) borrows funds in one currency (via a short sale of T-bills) and invests the proceeds in a higher-yielding investment. For years, traders carried their trades in Yen due to the low interest rates. And then more recently, the dollar-carry trade has been all the rage given the Fed's ZIRP (zero interest rate policy). To hep put the importance ot what is happening into perspective, understand that a "carry trade" is a staple of global macro hedge funds. It's simply a type of trade they most of these funds use - to varying degrees, of course.

In particular, he says this was a "dollar-carry/risk trade," wherein investors borrowed dollars to buy relatively riskier stocks. Since they believe that the Fed will keep its word (which may or may not be the case), these investors figure that stocks will have a better return over the next 20 months than T-bills which should pay a very, very low interest rate over the same period due to the Fed's action. Once that buying began, the market gained momentum, which led to wider-spread buying as the followers began to buy stocks.

This isn't a particularly optimistic play. These investors are merely betting that over the next 20 months, the return on stocks will be greater than approximately zero. If that's optimism at a time when a nation's economy is expected to recover, then I'd hate to see pessimism. And indeed, Wednesday reminds us never to pay too much attention to the stock market's performance during a single day. As of noon, the major indices are down between 2% and 3%, giving back most of Tuesday's gain.

Read the full story at Business Insider.