The recovery in U.S. stock prices off February’s lows was to be expected.
Trading a couple of standard deviations away from key short-term moving averages typically is a sign that the rubber band has been stretched in an unsustainable fashion in key benchmark indexes. What we are seeing in the stock market is a reversion-to-the-mean type of trade, which is normal after the rally we experienced in January.
Still, there is a fly in the ointment that needs to be monitored, as it indicates that large institutional investors are pulling in their horns. That fly in the ointment is the Japanese yen (see chart).
The last time we experienced a sharp yen appreciation was in 2016, when there was pronounced volatility in world stock and commodity markets. The yen rallied from over 120 to under 100 that year only to weaken dramatically all the way to 118 by the end of 2016 after the U.S. presidential election. (A rallying yen means the USDJPY, +0.07% chart is going lower, since fewer yen per dollar means an appreciating yen.)
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Why worry about a rallying yen?
In my experience, sharp rallies in the yen are in many cases correlated strongly with institutional investor cautiousness. Two decades of extremely low short- and long-term interest rates caused the yen to become the world’s favorite carry-trade funding currency as the cost of financing carry trades was negligible due to the unfortunate deflationary environment in Japan (see chart). A sharply rallying yen in the past two decades has often meant that institutional investors are unwinding carry trades.
Why would the yen rally if carry trades are being unwound?
Carry trades are only available to institutional investors with access to the short-term Japanese funding markets whose interest rates are heavily influenced by the Bank of Japan policy rate, which is -0.10%. While many forms of short-term wholesale funding in Japan are not negative, they are very close to zero.
In a carry trade, an institutional investor receives short-term financing from the yen-funding markets and buys assets with the yen-denominated loan. If the institutional investor buys assets in Japan, the loan remains in yen. However, large multinational institutional investors in many cases obtain low-interest-rate yen financing and buy assets outside of Japan. This involves selling the yen and buying the foreign currency those assets are denominated in. This yen-funding of foreign-currency-denominated carry trades creates a large synthetic short position against the yen, which causes the yen to rally sharply as those carry trades are liquidated and the borrowed yen is bought back to repay the yen-funded loans.
I think we may be experiencing this very dynamic at the moment. If many institutional investors try to reverse yen-funded carry trades in a short period of time, the yen tends to rally sharply. This is why when the stock market rallies and key commodities experience a rebound while the yen is sharply appreciating, as it is now, I tend to view those asset price recoveries with suspicion as institutional investors — the so-called “smart money” — may very well be unwinding carry trades and selling into the rally.
Another dichotomy that needs to be discussed along with the sharply appreciating yen is that of the Nikkei 225 Index NIK, +0.54% itself. Naturally, the correlation between the Nikkei 225 and the dollar-yen exchange rate is much stronger, since a weaker yen has meant a stronger Nikkei and vice versa. This is due to the large percentage of exporters in the Nikkei 225 Index, where a sharply weaker yen means higher earnings per share for the exporters, whose earnings are in many cases 80% or more derived from outside of Japan.
It is natural that the Nikkei 225 has sold off in this latest move higher in the yen (indicated by a move lower in the dollar-yen cross-rate chart), but the correlation between the two has not been as strong in 2017 as in prior years. This is precisely why I viewed the breakout in the Nikkei 225 after the Japanese parliamentary elections in late 2017 with suspicion. While it was natural for investors to be excited after another mandate for reform-oriented Prime Minister Shinzo Abe, such a big deviation from the Nikkei-yen correlation has not been able to hold for long historically.
The U.S. dollar has a big ‘synthetic’ short
Much has been said about the weak dollar in 2017 also having a weak start to 2018 (see chart). As I have said previously, I think this is more political in nature as the largest component of the U.S. Dollar Index — the euro at 57.6% — had the pricing of the eurozone disintegration trade wrung out of the currency markets due to a wave of pro-EU victories in Europe. No such pro-EU political developments are expected in 2018.
Also, there was a sharp increase in dollar borrowings in the past 10 years — to the tune of over $9 trillion as reported by the Bank for International Settlements (see April 12, 2015, Bloomberg article, “The $9 trillion short that may send the dollar even higher”). At a time of rising short- and long-term U.S. interest rates, this could create a massive short squeeze in the dollar, too (see chart).
In fact, I would not be surprised to see the dollar and the yen rallying at the same time at some point in 2018, even though the yen is a 13.6% component of the U.S. Dollar Index DXY, +0.28% The yen has been known to act as “a fish swimming against the current” in dollar appreciation environments because of the carry-trade unwinding. As to the synthetic short against the dollar due to too much dollar borrowing, it’s too large to ignore in an accelerating Federal Reserve tightening cycle.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.