BORIS SCHLOSSBERG<strong><br />DIRECTOR OF CURRENCY RESEARCH, GFT</strong><br /><br />NOW that the dollar has replaced the yen as the primary carry trade funding currency, the greenback has become even more sensitive to risk assumption and risk aversion flows. Since the carry trade depends on stable or widening interest rate spreads, any hint of economic turbulence will spark fears that central banks could lower rates, diminishing the strategy’s returns. That’s why the carry trade is so closely correlated with equity prices and why the dollar only rallies when stocks fall.<br /><br />So what can make equities decline this week? The G20 meeting, which is creating anxiety among traders about sweeping financial regulatory reform. Ahead of the summit, which takes place over the next two days in Pittsburgh, the rhetoric has been decidedly confrontational. For example, Jose-Manuel Barroso, the European Commission’s president, suggested the EU should impose limits on bankers' bonuses even if the US does not agree.<br /><br />As well as looking at action on big bonuses at bailed-out banks, G20 politicians are also considering higher capital requirements for banks and provisions to hold more liquidity.<br /><br />If the rhetoric actually turns into policy action, the news of further government regulation of capital markets could cast a pall over risk assets and precipitate a profit-taking sell off that many analysts have been anticipating. <br /><br />With sentiment data indicating that short dollar futures positions are at record yearly highs on the Chicago Mercantile Exchange, conditions are ripe for a swift short covering dollar rally this week – especially if concerns over the G20 agenda fuel further risk aversion flows that send equities lower as the week progresses.<br /><br />Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read their daily commentary on currencies at www.GFTUK.com/commentary or e-mail your questions to them at BorisandKathy@gftuk.com.