Tuesday’s gains left investors with two questions: “Is the selling over?” and “When should I buy?”
Wall Street thinks the worst is over, but to truly wrap our heads around what’s going on we must voyage overseas to Japan to study the so-called carry trade.
That’s because the Japanese yen has found itself tightly correlated with US tech stocks — which have been powering the market this year.
Currencies fluctuate relative to each other largely based on interest rate differentials, haven flows during times of panic, and international trade.
Japan has been mired in a decades-long deflationary spiral, from which it is only now climbing out, and its rates have correspondingly hovered around the zero line for decades. As the world’s last holdout with negative rates, it climbed into positive territory only this year when it hiked to 0.1% in March — then again last week to 0.25%.
Meanwhile, rates in the US have been north of 5% for a year and the European Central Bank sits just under 4%, having cut in June.
Out of this large gap, an entire cottage industry of investors emerged who borrow cheaply in Japan, then reinvest in higher-yielding assets elsewhere. It’s called the carry trade.
“[A] lot of speculators went and borrowed in Japan at zero interest rates,” said Yardeni, who explained that the borrowed yen was then converted into dollars and other currencies.
“The yen weakened, the dollar strengthened, and they took that money and invested it in assets around the world,” he said.
Since 2010, this persistent selling pressure on the yen, combined with the corresponding bid on the US dollar, has made the dollar twice as valuable as the yen — a stupendously large move for a developed-world currency.
The crashing yen even led the Bank of Japan to intervene at times, but ultra-low rates encourage capital flight. And now that the BOJ is raising rates, the engines are reversing, along with the international money flows back into the yen.
Leverage and volatility act as masochistic siblings, feeding on each other during times of strife — wiping out pyramided positions. Movements that would normally take months occur in the span of a few days.
Markets survived the first round of margin calls Monday and Tuesday, but bear markets don’t occur overnight. When looking for clues about future direction, investors should also consider the backdrop in US markets.
In the back half of July, investor portfolios had already been subjected to a gut-wrenching rotation from megacaps into small caps and value sectors.
Throw in some recession fears stoked by softening US economic numbers along with a Fed chair with an index finger on the “cut” button, and investors themselves were quick to press “sell.”
Wall Street is leaning toward a fairly quick resolution of the episode. Morgan Stanley’s sales desk wrote to clients, “We are closer to the end of the selling than to the beginning.” JPMorgan’s co-head of FX strategy Arindam Sandilya believes we’re 50% to 60% through the carry unwind as of Monday.
For his part, Yardeni sees the end a bit sooner: “The unwind should be over by the end of the week.”
