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The S&P 500 and the Yen Carry Trade

May 16, 2011 Guest Commentary by Jason B. Leach, CFA

Note from dshort: Jason Leach is the Director of Research and Portfolio Manager of Cravens Brothers Wealth Advisors. Frequent visitors to this website may recall his fascinating Age of De-Leveraging from this past January. A currency carry trade strategy involves borrowing (i.e., selling) a currency at low interest rates (e.g., Japanese Yen), and using those funds to invest in higher yielding countries/assets (e.g., Australian bonds) thus taking advantage of the difference in interest rates. The “yen carry trade” has been in vogue since the mid-90s when the Bank of Japan set interest rates at very low levels in an attempt to stimulate the Japanese economy in the midst of its “Lost Decade.”

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Many traders actively track the yen carry trade through currency crosses such as the EUR/YEN (Euro/Yen) and AUD/YEN (Aussie dollar/Yen) because these currency crosses tend to be positively correlated with broad equity indexes such as the S&P 500. This correlation exists because investors borrow yen and invest in “high yielding” equity markets.

Historically, I have watched EUR/YEN and AUD/YEN pre-market to get a feel for where the U.S. equity markets would open, and I follow the crosses during the day as they may signal a move. But in August 2010 the “yen carry trade” indicators stopped working. Not only did they stop working, but they stopped working precisely on the day Ben Bernanke gave his Jackson Hole return to quantitative easing (“QE II”) speech. Since that speech, the S&P 500 has climbed approximately 28% while the EUR/YEN cross is up just 6% and the AUD/YEN cross is up 13%.

Assuming the very high correlation between the S&P 500 and the yen carry crosses returns, as it did following the end of QE I in March 2010 (see the May-Aug 2010 correlation in the chart), the question I have is this: Will the yen carry crosses rise 15%-20% to meet the S&P 500 or will it be the other way around?

I never rely on just one indicator to develop any market opinions. I prefer a “mosaic” approach. But, the yen carry cross chart certainly has my rapt attention.

View the original article on dhsort.com

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