FYI | Sep 05 2007
By Chris Shaw
For the last month the volatility in global investment markets has made any discernible or sustainable pattern difficult to identify, but one trend that has emerged in recent weeks is the inverse relationship between equity prices and the level of the Japanese yen.
The relationship was clearly displayed when equity prices were plummeting in early August, as the yen rose strongly at the same time and reversed (for a while at least) what had been a long-standing trend towards a weaker yen as investors and traders alike put on the carry trade.
Why the carry trade became so popular at least in part is the dissatisfaction on the part of Japanese investors with the returns available from domestic investments, which forced them to send money offshore to invest in higher yielding foreign assets.
When this strategy showed good gains others quickly came to the party and the carry trade became a staple of global investors at least until last month’s credit crisis caused funds to be withdrawn from various assets, so sending the yen higher and wiping out carry trade returns.
This scared investors and they also returned to the US dollar, though one may assume this was due largely to its safe-haven status. It certainly wasn’t due to the increased attractiveness of the US dollar from an investment standpoint, as the current economic fundamentals in the US are more suggestive of currency weakness than strength.
The US dollar hasn’t had the same level of correlation with equity prices as has the yen though, meaning the Japanese currency continues to be the global market’s barometer of risk, a point market commentator Dennis Gartman of “The Gartman Report” has been making for some time.
Silicon Valley Bank’s currency specialist Fernand Kong notes in recent weeks equity prices have recovered as the market prices in cuts to official interest rates in the US, meaning the yen has again weakened and higher yielding currencies such as the Australian dollar and the British pound have strengthened.
While this suggests a return to the carry trade he points out such positions are being held for a shorter time than was previously the case, which indicates investors remain nervous as to how markets will trade in coming weeks.
Assuming the expected interest rate cuts in the US materialise Kong sees scope for equity prices to push higher, which would put the yen under further pressure. This means despite the currency being undervalued on most measures it is likely to remain cheap for some time, though of course if Federal Reserve chief Ben Bernanke doesn’t deliver on the expected rate cut this position could quickly reverse.
