Yen’s Strength [has been] profoundly negative for global markets
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March 27th, 2008 by AdvisorAnalyst
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March 27, 2008 - Donald Dony, The Technical Speculator, offers the following explanation of how the strengthening of the yen to a twelve year high against the US dollar has had a profoundly negative effect on global markets, in the past and during the most recent 6-7 months. We would also add that while Mr. Dony does a great job of explaining this concept, he also points out in the present tense that as the cheap money is quickly evaporating, so is the global market.
Our sense is that the yen broke through par, a level (usd/yen<100) that required intervention (which came last week), primarily by the BoJ to maintain it at levels that are more supportive of Japan’s economy. For this reason, it may be that if the yen has reached a turning point, that a new round of carry trade in the yen could provide stimulus and/or support to global markets at these levels. Change that to evaporated, past tense.
Global equity traders had, for many years, a ready source of funds at almost no interest charge. Traders have been shorting the Yen and using the funds to purchase stocks, currencies and high-yielding securities around the world. However, as of mid-2007, that “free bank account” is becoming more and more costly. The Yen carry trade is starting to unwind with very negative results for stocks.
But what is the “Yen carry trade”? Simply put, it is borrowing at very low interest rates in Yen and using the loan to buy higher yielding assets elsewhere. During the past 12 years, the trade has become standard business practice for many institutional investors. Perhaps the most popular form of the strategy exploits the yield gap between U.S. and Japanese fixed income securities. Another plus that came with the Yen/U.S. cross was from the dollar’s rise against the yen. Investors make their profit when they reverse the trade and pay back the Yen loan.
But all of this endless liquidity is quickly coming to an end and with bearish consequences to global equity markets.
Chart 1 illustrates the tight connection of the Japanese currency with global stocks. With every major rise of the Yen throughout 2007, there was a mirrored decline in the Dow Jones World Stock Index. Quite simply, the global equity markets began to fall when the tap was turned off to cheap money. Traders are now forced to buy back massive Yen short positions and sell assets to pay for it.
And what is happening to the Yen?
Chart 2 shows the Japaneses currency is breaking through a decade old resistance levels and surging to new highs. And this trend shows no signs of reversing. The upside target is 120.
Bottom line: The bearish impact of the advancing Yen is clearly apparent on global stock markets. World equities appear to have been propped up largely due to the availability of foreign liquidity. As this “cheap money” is quickly evaporating, so is the global bull market.
Donald W. Dony FCSI, MFTA
Read more from the author/contributor here.
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