For investors, the sharp rise in the Japanese yen Thursday morning is a far more alarming market signal than most realize.
The problem is that an unknowable vast sum of investment funds has been borrowed in yen and used to invest in U.S. assets, helping push the S&P 500 higher. Now, the process is working in reverse – U.S. equities are being sold to repay the yen loans. The effects of this "unwinding" of the yen carry trade were visible early morning Thursday as the Japanese currency jumped higher in foreign exchange markets despite recent Bank of Japan policy to accomplish the exact reverse, a weaker yen.
The exact mechanics of the short yen and long U.S. assets trade are not that relevant for the average investor but for those interested, they were detailed in a late 2014 speech by Hiroshi Nakaso, deputy Governor of the Bank of Japan. The ramifications for domestic investors are, however, extremely important. In effect, a falling yen has been a "risk on" indicator for developed equity markets as a sign of investment inflows from Asia.
The top chart compares the value of the yen in U.S. dollar terms with the United States-based CBOE volatility index. The latter is widely used as a proxy for U.S. risk tolerance – rising during equity market sell-offs – which is why it's frequently referred to as the "fear index." In recent weeks, changes in the VIX and the yen have become extremely closely tied – an indication that U.S. market weakness and yen strength are related phenomenon.
The second chart is far more dramatic. Plotting changes in the S&P 500 and the U.S. dollar in yen terms since 2010 shows the lines have moved together. (The mathematical analysis, by the way, is more remarkable than the chart looks. The "R-squared" – coefficient of determination – is a whopping 0.96 for the period. A reading of 1.0 is what happens when you compare a data series to itself.)
For Ken Veksler, a foreign exchange trader for Britain-based Accumen Management, the trend of falling developed-world equity markets and a rising yen "is an unwind of a vastly overleveraged position [and] the abandonment of positions that made little sense six months ago and now look like lunacy." The words "vastly" and "lunacy" are for me an indication of how far the painful process of unwinding this leverage might have to go. A huge amount of money allocated to lunatic investment ideas (when I asked him, Mr. Veksler said it was long positions in the S&P 500 that he had in mind when he wrote this) could take a while, and a lot of equity index points, to reverse.
Personally, I'm well aware that the last time Canadian investors paid close attention to Japanese markets was somewhere around 1995 and they are probably reluctant to read about them again. I wouldn't be writing this unless I felt it was extremely important in the current environment, particularly for investors looking for the "all clear signal" that it's time to put cash to work in equities markets, whether domestic or foreign. As long as the yen is climbing, I strongly suspect it's not time yet.
Follow Scott Barlow on Twitter @SBarlow_ROB.