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Tuesday’s rally left investors with two questions: Is the selloff over? “When should I buy it?”
Wall Street thinks the worst is over, but to truly understand what’s going on, you need to travel from overseas to Japan to study the so-called carry trade.
That’s because the Japanese yen has been found to be closely correlated with US tech stocks, which have been driving the market this year.
Currencies fluctuate relative to each other primarily based on interest rate differentials, haven flows during panics, and international trade.
Japan has been in a deflationary spiral for decades and is emerging from it, but interest rates have also been hovering around the zero line for decades. As the last holding country in the world with negative interest rates, it only moved into positive territory when it was raised to 0.1% in March this year, and rose again to 0.25% last week.
Policy interest rates of central banks around the world
Meanwhile, interest rates in the United States have been above 5% for the past year, and the European Central Bank cut them in June, leaving them at just under 4%.
Out of this huge gap has emerged a whole cottage industry of investors who borrow cheaply in Japan and reinvest in other high-yielding assets. This is the so-called carry trade.
Ed Yardeni, president of Yardeni Research, appeared on Yahoo Finance’s Morning Brief Show to clarify the details.
“(A) lot of speculators went to Japan and borrowed at zero interest rates,” Yardeni said, explaining that the borrowed yen was then exchanged into dollars and other currencies.
“The yen weakened, the dollar strengthened, and they invested that money in assets around the world,” he said.
Since 2010, this sustained selling pressure on the yen and the corresponding bid for the US dollar has made the dollar twice as valuable as the yen, an extraordinary move for a developed country currency.
The collapse of the yen sometimes prompted the Bank of Japan to intervene, but ultra-low interest rates encouraged capital flight. Now, as the Bank of Japan is raising interest rates, international money is flowing back into the yen, and the engine is turning in reverse.
Leverage and volatility act as masochistic siblings, feeding on each other in times of conflict and wiping out pyramidal positions. Movements that would normally take months are completed in a few days.
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The market weathered the first round of margin calls on Monday and Tuesday, but bear markets don’t happen overnight. When looking for clues about future direction, investors should also consider the US market context.
Already in late July, investors’ portfolios were undergoing an arduous rotation away from mega-caps and into small-cap stocks and value sectors.
Coupled with recession fears fueled by weakening US economic data and the Fed chair’s trigger finger on the “lower down” button, investors themselves were quick to press “sell.”
Wall Street is leaning toward resolving this case fairly quickly. Morgan Stanley’s sales desk sent a letter to customers saying, “We are nearing the end of the sale, not the beginning.” Arindam Sandriya, co-head of currency strategy at JPMorgan, believes carry unwind is 50% to 60% achieved as of Monday.
For his part, Yardeni thinks the end will come a little sooner: “The relaxation should be over by the end of the week.”
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