oftwominds-Charles Hugh Smith

The Yen Revisited


Knowing my skills as a chartist are weak at best, I asked frequent contributor Harun I. to check my recent (Oct. 15) comments on the yen carry trade. Alas, I had the yen's movements exactly backwards. Here is the correct interpretation.

Please go to www.oftwominds.com/blog.html to view the charts.

Yes, I am an idiot, but it turns out there are two ways of charting the yen: a currency chart and a Forex chart, and I confused the two. Each is a mirror image of the other.

Now that we have that straightened out, we can see the Yen strengthened July - September, as we would expect as the dollar lost value. But then starting about October 1, the Yen started weakening along with the dollar.

In my view, this suggests central bank intervention to weaken the yen back to the 117 level, regardless of how low the dollar fell. Recently--just the last few days--this attempt to weaken the Yen in tandem with the dollar appears to have failed, as the yen has now risen back to the Carry Trade's profitability "line in the sand" around 115.

Why should you care what the Yen does? because if I'm right, then next week will be a blood-bath in the U.S. and global stock markets. The U.S. markets have roared up the past 7 weeks, invigorated by the Yen Carry Trade which got a new lease on life as the Yen weakened to 118.

But in the past two days it has reversed direction and started strengthening again to 115. Below 115, the carry trade is no longer a low-risk bet. As dollars leave the U.S. markets to be repatriated into Yen, the U.S. markets plummet. Of course there are many other knives embedded in the back of the U.S. Market Monster--renewed credit contraction, risk aversion, insanely overvalued tech stocks, weakening corporate profits, rising energy prices, rising inflation and a collapsing housing market, just to name a few.

On Monday (Oct. 15) I was seeking some correlations between the Yen and the Dollar and the U.S. stock market. I asked Harun for help, and he sent these charts. (The comments on the charts are mine.) Here is the Yen and Dollar:



And the Yen and the Dow Jones Industrial Average (DJIA):



Clearly, there is no one correlation which remains constant. Are there some correlations in certain time frames? It pays to be careful before reaching hard-and-fast conclusions. Here are Harun's comments:


"One thing that must be cautioned against is making conclusions from too little data. To investigate the media pundits claim of what is happening to the yen vs. the market (Dow Jones Industrial) we begin by visual inspection of a longer-term chart.

A cursory visual inspection of the Dow (red) and Yen (black) shows that from 1985-1995 the Yen and the Dow were in a bull market. It is worth noting that during this period and beyond, the Nikkei was in secular bear market. In 1995 the Yen peaked and then descended rapidly, bottoming in 1998. During this time the Dow remained in a bull market and the Nikkei was still in a secular bear trend.

Off the 1998 bottom the Yen rallied coincident with the Dow until 2000. At this time both peaked and began to decline however there are times when they were notably out of phase by 180 degrees (mid-2001 and early 2002). Both rallied again in 2003 into early 2005. Since then the Dow has rallied and the Yen has declined. (my emphasis added--CHS)

Even with this cursory analysis we can see that movement of the Yen at times is coincidental but not correlated to the US market. If one looks at the Yen price line one can see that it has been tracing out an ever-decreasing range of trading for the duration of this weekly chart. This formation means something and must be watched because breakouts of tight price formations at the primary and intermediate levels (long-term) usually lead to sustained long-term trends.

As for the Yen/Dollar relationship it must be understood that the Dollar has no futures contract. The USD Index is a geometrically weighted index of six currencies, with the Euro and the Yen having the greatest weight. Because of this weighting the Yen can and does move coincident with the USD. Most of the time the movement of the Yen is opposite USD and correlated.

A rising Yen line (black) indicates strengthening against the USD and vise versa. A rising USD (blue line) indicates a general strengthening against the indexes component currencies. With that said it should be noted that currencies carrying the least weight (Canadian Dollar, Swedish Krona) might have spectacular runs that have little affect on the USD Index.

The peak and troughs of the USD and Yen in 1995, 1998, 2000, and 2005 show opposite but not equal ends of the spectrum. Second quarter 2006 a decline in both can be seen. How does this happen? The other currency components of the USD Index, i.e., the British Pound, Canadian dollar, the Euro and Swiss franc have been acting rather bullishly. The decline of the Yen is the only thing standing in the way of a more pronounced decline of the USD. Carry trade or no, if all component currencies start rising the USD will decline.

A word about the carry trade: Much ado about something that is old hat. It is not the job of traders and investors to set economic policy. It is their job to take action to earn returns that increase or maintain purchasing power. Carry trades do not distort the market. The distortions seen today are the result of flawed economic policy. Investors and traders must exploit the foolishness of flawed government policy or be victimized by it.

Does the Japanese Central Bank intervene to protect Japan's economy? Of course, with the world's second largest economy being export based and most everything dollar denominated, they can and will intervene to keep their exports attractive.

Is it advisable in the long-term? Probably not; empirically, over the long-term such manipulations if not backed up by sound fundamentals lead to market corrections that become uncontrollable by any one entity. Power laws suggest that the less frequent an occurrence the more significant it is but that is another topic.

From an anecdotal perspective we can conclude that media pundits are falling prey to what is known as recency bias (weighing recent data more than earlier data) and belief in small numbers (drawing unjustified conclusions from too little data). The proper way to research this would be to run a correlation study.

This too, however, can be subjective. Do you do it on a one to one basis, which may not reveal trends well, or over an average time period? If we do it over an average period we would have to determine the length of the average that produced acceptable statistical relevance.

The media want us to believe in easy answers but there are none to be found."

Thank you, Harun, for your enlightening commentary. Even as I try to absorb Harun's analysis, I note the Yen has broken 115 as I write this Friday-- a line which I have noted (anecdotally, and yes, recently) seems to correlate with the U.S. stock markets dropping like proverbial stones.

If this is truly correlated, next week could be a real blood-bath in the U.S. (and global) stock markets.

I also asked Harun to comment on the Yen and Dollar's correlation to exports, i.e. Japanese exporting companies like Honda and Sony selling goods in the U.S. for dollars and then selling those dollars for yen. Harun made these observations about currencies, risks and hedges.

"Each exporter can decide how it will accept payment. If I want to be paid in yen the purchaser of my goods must sell their currency and buy yen. If I want to be paid in dollars then the importer has to come up with them and the exporter must convert those dollars into yen. Each has risks. For simplicity the exporter must protect against a decline in its domestic currency and an importer must protect against the strengthening of the foreign currency.

With that said, the BOJ doesn't want the yen to become too expensive or it will hurt the overall economy and even though it is frowned upon the BOJ does intervene to control the yen. This is short-term and at times as seen on the chart it fails.

Back to the risks.

If the Japanese exporter wants yen for his goods the risk is that the yen will weaken and therefore the exporter should short yen as a hedge. When we look at the COT data we see that Large traders are increasing net short positions and therefore Commercials are slightly net long suggesting that they are hedging against a rise or strengthening of the yen and simultaneously accumulating yen at lower prices.

Regardless of the complexity of these interactions we know that when these positions are lifted price will react. It is here we can use technical tools to gauge where support and resistance reside and place our bets.

To complete the circle, Banks and investors are looking to make money on interest. If you have a credit card with a 0% teaser rate it makes sense to use that card to purchase that plasma screen television than a 13% bank loan. So in that vein the carry trade makes perfect sense. It is simply good business to make money off the spread in the yield.

The market doesn't open the spigot, the Central Banks do. Their price control of money is what causes distortions. Leave the spigot open too long and a flood occurs. Leave it shut too long and there is a drought. Both are extremes and both are undesirable to the stability of an economy. As we have seen the market will turn off the spigot of liquidity when its interests are threatened.

Economic theory is both right and wrong. Price controls don't work, this is empirically proven. Human beings are not rational actors, this also is empirically proven. The economic tools the Fed uses (at least the ones released to the public) to gauge the economy have been hijacked and are no longer economic but political tools use to hold onto power. Of course this involves the requisite lying, cheating and stealing.

I would say that greater economic literacy would help but no amount of education will overcome greed. What is needed is a sense of responsibility to the generations that will follow but once again that also takes a back seat to profits.

The situation has become Darwinian, we either adapt (learn how to play the game and live ( maintain our standard of living and pass something on to the next generation) or we fail to adapt and perish (live in poverty). "

Thank you, Harun, for illuminating some of the dark corners of the currency /carry trade, and for addressing market correlations.


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