One of the most significant developments in financial markets may well be unfolding before our very eyes. No, this is not equity or commodity markets rising; this has been obvious for at least three months now. These trends are broad based and very healthy. It is not the breakdown in treasury or investment grade debt markets, that is way too obvious. I am referring to the Yen crosses. Why is this significant?
Well, to get straight to the point - there can be no bull market in commodities or equities unless there is confirmation in the carry trade. We are likely to see changes in liquidity, which is the life blood of rising equity and commodity markets, show up first in the carry trade and last in the major market indices like the Dow and CRB Index. Well, the good news for the risk trade camp is that the Yen crosses are poised to breakout after a 6 month old basing pattern. In fact, a number of crosses have already broken out (the AUDJPY and ZARJPY come to mind).
I have been perplexed at how the Yen crosses have not managed to breakout given the strength of emerging market equities and commodities, two markets which have historically been very correlated with the Yen crosses.
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For years, the Japanese have had to contend with deflation. In fact, everything in Japan seems to be geared towards deflation, with investment funds, allocations to JGBs at a record high, and exposure to Japanese equities at a record low. Now, what would happen if Japan started to experience inflation? I guess betting on inflation in Japan (long Japanese equities, and shorting the Yen and JGBs) would be up there with the world's most off the wall contrarian trades. But don't laugh out loud, inflationary pressures are building rapidly on a global scale. Combine this with the debt levels in Japan running at 200% of GDP and you have a recipe for disaster, or should I say, collapse in the Yen and JGBs. I think shorting the Yen could well be the safe haven trade over the coming months.
