By Chad Karnes
The U.S. Federal Reserve's dual mandate is to maximize employment and combat inflation, nothing else right? Well, if Japan's central bank and monetary policy is any sign, the Reserve banks of the world also likely control the equity markets too, unintended consequences or not.
The chart below is all I need to see to realize that indeed the world's banks' easing and currency policies directly affect equity markets. This chart adds empirical data where most already have assumptions and gut feelings of a Fed driving equity markets, just this one is occurring on the other side of the world.
Yen Carry Trade
The Yen (NYSEARCA:FXY) carry trade was a popular vehicle for profits by the big banks in the mid-2000's. A carry is when an investor borrows at a low interest rate in one country (Japan for instance) and then buys a strong currency or asset in another country such as the United States (NYSEARCA:VNQ) or Europe (NYSEARCA:VGK) that has a higher interest rate. The investor collects the interest and may even pocket currency gains.
Right now the Yen Carry trade is back in full effect as the Yen falls and markets in countries with higher interest rates around the world climb.
A recent media report titled, "Yen Carry Gauge is at 2008 highs" showed similar findings. In that article they claim that, "foreign banks' lending in Japan to their main offices, an indicator of demand for the Yen to fund purchases of higher yielding assets, climbed for a fourth month in November 2013 to 8.3 trillion Yen ($79.5B), the most since December 2008".
Investors are using the Bank of Japan's easy money policies to borrow (sell) Yen and buy assets around the world that provide higher returns. The chart below shows the extremely high correlation between the Japanese Yen and the Japanese equity market (NYSEARCA:EWJ) and proves that a weaker Yen is driving equity markets. One of the lines is the Yen (rising=weakening) and the other is of the Japanese stock market.
Investors are borrowing Yen and purchasing stocks around the world.
The Yen Drives the World Right Now
In a recent ETFguide.com Technical Forecast I showed the extremely high correlation doesn't stop at the Japanese stock market, but also is very present in U.S. equity markets as well. The U.S. stock market performs nearly opposite the Japanese Yen.
So long as the Yen weakens, U.S. stocks will continue to rise.
Since February, the Yen (NYSEARCA:YCS) has weakened 2% while the U.S. equity market (NYSEARCA:SSO) has gained. This works on a long term basis but also on a daily basis as pretty much every day the Yen weakens the equity markets around the world are up. This even often works on a minute by minute basis.
On Monday's (3/3) big equity market decline, the Yen had already strengthened Sunday night, sending the futures markets down overnight. On Tuesday's huge market recovery, the Yen weakened (NYSEARCA:YCL) substantially overnight so by the time the U.S. markets opened, they played catch up by rallying. On Wednesday's flat market day, the Yen too was flat. On Thursday's muted rally, the Yen had already weakened substantially overnight. If the Yen weakens what do you think will happen to the world's equity markets?
The Yen is driving all the major equity markets around the world and is likely one reason we see such high correlations amongst most asset classes.
To be an equity bear you need to be bullish the Yen. In a recent update I explained why I am more bullish the Yen than bearish and thus, as a result, they should expect an equity market selloff with a Yen that should strengthen through 2014.
In order to be bullish equities, you therefore must assume the Yen will continue to weaken. It also assumes, amongst other things, the Yen will slide further, after an already 30% decline in value from its 2011 stronghold. That scenario seems less likely to us.
Link to the original publication on ETFguide