Getting Carried Away?
by Brian Pretti CFA, Contrary Investor. October 26, 2007
In a number of recent discussions, I've expressed my concern over the character of current circumstances in the US credit markets. I remain convinced that financial market and real economic outcomes moving forward heavily depend on US credit market outcomes. Without going into massive detail, Fed rate cuts up to this point have done absolutely nothing to stop the erosion in asset backed commercial paper markets (ABCP). Nothing. As of the latest data (Oct. 23rd), ABCP continues its literally uninterrupted contraction started this summer. Moreover, Fed rate cuts have done nothing to stop the contraction in mortgage credit availability stateside, although admittedly this is a bit unfair as the first rate cut occurred a whopping one month ago. But you get the picture. In many senses, the Fed can cut all they want and literally go on a repo issuance rampage. The main question of the moment is can the US credit markets heal enough to provide the circumstances for reacceleration of the macro US credit cycle? Yes or no? Moreover, even if this were to occur, will households then borrow and spend at ever-greater levels? Again, it all comes back to the credit markets. Having said this, as it applies to the financial markets, we need to keep our eyes on one other important ball at the moment - the Yen carry trade.
Alive And Well, And Living In Manhattan (and Greenwich, the Caymans, London, etc.)
The Yen carry trade is certainly a very important "other side" to the total financial market story, especially as far as the equity markets are concerned. It's time for a brief check in. Why? Well, almost magically on cue, as of August of this year, the year over year rate of change in the Japanese monetary base has again turned positive. Once again, the BOJ is on the job as the global liquidity quickie Mart we've all come to know and love.
From extraordinary rate of change expansion early in the current decade to draining serious money from the system post the G7 meeting of early 2006, the BOJ is now once again expanding the monetary base as the Japanese economy has been slowing as of late, and is probably already in recession as we speak. In no way am I suggesting that the BOJ is about to bombard the world with new Yen by any means; they've been doing that for quite some time, but the fact that the liquidity drain of the past year and one half appears to have concluded is indeed significant. And despite readily apparent global credit market issues de jour, the Yen carry trade as a separate and distinct item remains very much alive and well as we speak. Although it is clear that the global central bankers of this Earth have more than done their fair share of liquidity expansion/creation as of late, I'd have to say that looking at the facts, the Yen carry trade remains a meaningful force in supporting global equity markets, while global credit market fires either smolder or burn as we speak. Many a credit market analyst may have taken his/her eye off of the carry trade ball as of late, given the significant US mortgage related collateral questions of the moment, but we need to remember that the Yen carry trade to this day remains a force to be reckoned with that underpins the ongoing directional change in the really global equity markets. And clearly at this point, given negative US credit market issues that have clearly spread globally, the central bankers around the planet have to be racking up a few more long distance phone bills as of late.
In the charts below I'll show you exactly what I'm talking about, and hopefully a few technical signs to watch for as we move ahead that may indeed provide directional guidance as to the twists and turns in both the US and emerging equity markets. First, please be forewarned that I'm only using year-to-date data here. In no way can we generalize about the long term when analyzing short periods of financial market experience. But the reason I'm homing in on the short term is that this is what is working now. Will it always be that way? I have absolutely no idea, so we work with what has been working in recent market experience until it's no longer valid. I believe that in many ways, what has transpired this year in both Yen movement and in the clear carry trade relationships is indeed in part reaction to the US credit cycle. Let me try to explain.
In the first chart below, we're very simply looking at the Yen itself with the Dow Jones imprinted below the Yen chart. I've colored in the pronounced periods of Yen weakness this year. It just so happens that the periods of interim Yen weakness this year corresponds to the entirety of Dow price gains year-to-date. Message being, the time to be long the Dow is when the Yen is in decline. Another way to phrase this is, the Yen carry trade is on when the Yen is in decline, the proceeds of which line up virtually perfectly with gains in the Dow. Evidence of the yen carry trade in action? If not, then just what are we looking at? As you can see, each interim meaningful peak in the Yen corresponds perfectly with significant lows in the Dow YTD.
What I've also done is have a look at the 30-day rate of change (ROC) in the Yen in the final clip of the chart. Once again, peaks in the 30-day ROC for the Yen correspond exactly with nominal value highs in the Yen and important lows in the Dow. That's all well and good, but only really helpful after the fact, as no one in foresight can "see" either an interim peak in the Yen or its 30-day ROC. That being said, here's what I hope is helpful. I've marked in blue lines the points where the 30 day ROC in the Yen has gone from being negative and crossed through zero for the first time after extended weakness. It just so happens that these points immediately precede meaningful interim peaks in the Dow by literally days. At least that was exactly the case in February, July, and October. Will it be so again?
To be honest, I'd virtually dismiss this outright if it applied only to the Dow, but it does not. In the chart below, everything is as it is above with the exception of substituting the EEM - the Emerging Markets Index Fund - for the Dow. Notice anything?
You better believe there is something to notice. All of the characteristic relationships described between the Yen and the Dow hold for the EEM and the Yen. The entirety of YTD performance has been captured while the Yen has been in weakening mode. The 30-day ROC peaks for the Yen line up exactly with interim Yen peaks and exact lows in the EEM. And lastly, and more importantly, a cross of the 30-day ROC for the Yen above the zero line from below has occurred right in front of important interim peaks in the EEM.
As stated, I simply have no way of knowing if indeed these relationships hold up as we move ahead. But very importantly these relationships do indeed strongly corroborate the Yen carry trade as being very meaningful for both US domestic and global equity markets. For now, the Yen carry trade is very alive and well. Will this be one of the last global liquidity bubbles to pop at some point? Sure. Of course the trick is in the "when." Do I really have to tell you that it’s very important to watch the Yen? Good, I didn't think so.
© 2007 Brian Pretti