Fed Affirms New Course; Stocks Soar - Bezek's Daily Briefing

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Includes: CAT, FXA, FXC, FXE, FXY, KMTUF, KMTUY, QQQ, SPY, USO, XBI
by: Ian Bezek

Summary

Markets soar on the Fed minutes.

Don't get carried away, the move isn't indicative of a broad change in market direction.

The Japanese yen is rallying strongly. What's the impact for US-based investors?

For the moment, the bearish tide has been repelled. Wednesday brought the much-awaited Fed minutes. Contrary to the recent trend of doubletalk, the Fed confirmed the same message that Yellen had previously delivered: The Fed is less hawkish now.

Stocks surged on the message. The S&P 500 (NYSEARCA:SPY) jumped more than one percent. Not to be outdone, the Nasdaq (NASDAQ:QQQ) was up more than 1.5%. The day's shining star was biotech (NYSEARCA:XBI), which jumped an astonishing 7%:

XBI Chart

XBI data by YCharts

The chart resistance at 55 was decisively busted. If biotech is going to make a solid upmove, now is the time.

Joining healthcare on the biggest winners list were the basic materials. With crude oil (NYSEARCA:USO) up more than 5% on the day, it paved the way for the energy stocks to rebound.

It's easy after a momentous move to conclude that the market has entered a new trending move. As far as this one goes though, I'm not convinced. For starters, the S&P 500 didn't really accomplish all that much chartwise:

Click to enlarge

The S&P still sits well within the range that it has traded over the past week. And overhead resistance looms just above here. It will be a dogfight to try to get the next 50 points of upside.

The market had been setting up what appeared to be the beginning of a correction. The Fed's minutes took that off the table for the time being; we're back to the neutral zone. But don't get crazy aggressive chasing the upside. There's still a good chance things break down from near these levels. And as for oil, we're back to $38, dead center of the recent $35 to $42 range.

Japan: More Yen Trouble

One of the recent international themes has been competitive devaluation. With both the European and Japanese economies weak, both groups' political leaders have been pressured to devalue their currencies. This helps boost exports and hopefully improve the economy.

In recent years, the Japanese yen (NYSEARCA:FXY) fell from 75 to 125 against the dollar. That's a huge move for a top tier currency. The euro's (NYSEARCA:FXE) fall has been less dramatic, but make no mistake, a drop from 1.40 to 1.05 has a major impact on world capital flows.

The Fed's recent repositioning has caused general weakness in the dollar. Battered commodity currencies including the Canadian dollar (NYSEARCA:FXC), Australian dollar (NYSEARCA:FXA) and Mexican peso have all enjoyed 10%+ rebounds in recent weeks. These were acceptable moves, since the countries involved hadn't intentionally tried to devalue their currencies to the extent that they had fallen.

However, some of the other moves raise more concern. In particular, the Japanese yen has moved back up from 125 to 109. The yen plowed through 110 yesterday and continues to spike higher as of this writing.

This will have several effects. For one, Japan will see its already struggling economy take a leg down. To the extent it had any traction, the economy was winning in competition for manufacturing goods against the US. Think Komatsu (OTCPK:KMTUF, OTCPK:KMTUY) taking market share from Caterpillar (NYSE:CAT) for example. Bloomberg explains what happens:

Japan's Komatsu Ltd. is benefiting from the 20 percent plunge in the yen against the dollar since the beginning of July. That's helping it compete worldwide on prices for construction equipment such as excavators and dump trucks, according to Mike DeWalt, a Caterpillar vice president.

Caterpillar dealers say that when they are bidding for big deals, "maybe the Komatsu dealer is getting some help from the factory," DeWalt, who oversees Caterpillar's finance services division, said Thursday. "What we are hearing from dealers is Komatsu is being aggressive."

The competition between the two manufacturers illustrates how short-term gyrations in exchange rates can disrupt sales even as companies try to manage costs and other risks.

Caterpillar, the world's biggest maker of construction machinery, has 53 percent of its property, plants and equipment located in the U.S. While Komatsu also has factories around the world, 63 percent of its assets are in Japan, according to the most recent data compiled by Bloomberg. That provides a lower-cost manufacturing base, said Karen Ubelhart, a Bloomberg Intelligence analyst.

However, this impact will quickly reverse if the yen keeps rising. Japan will almost certainly try to do something to reverse the yen's recent strength. But their options are extremely limited. Having already pulled the negative interest rates lever, it's unclear what tools remain in the central bank's arsenal.

Switching gears, the yen's strength is also bad news for US equity markets. This is counterintuitive, since a stronger yen helps earnings for US-based multinationals.

However, here the carry trade is the key factor. For many years, currency traders, hedge funds and other sophisticated market actors have used the yen as a funding currency for carry trades. Let me explain.

A carry trade is a long-short investment where you buy a higher yielding asset and fund the trade by borrowing against something with a low interest rate. A classic example is emerging markets. Currently, you can borrow in the US at a trivial interest rate, and then lend - to give one example - to Brazil at 12%. All else equal, you make 11% a year, as Brazil pays 12% and you borrow at 1% or less in the US.

This can go bad if Brazil has high inflation or its loans default. But over time and with diversification of risks, the carry trade is a time-honored way of earning high returns with only moderate risk.

While the US dollar has generally been a fine funding currency for carry trades, the Japanese yen has traditionally been even better. For at least the past 10 years, Japanese interest rates have usually been among the lowest if not the lowest of the developed economies.

At present, speculators can borrow in Japan at more or less no cost and then use that capital to buy risk assets elsewhere. You can put whatever you want at the other end of the trade. Buy US utilities that yield 4% while borrowing yen at 0%? That's good. Buy US 10-year bonds at 2% while shorting Japanese 10-years at 0%? That works. The possibilities are limitless.

However, there's one big potential problem. If the yen rises, the trade backfires. The carry trade depends on leverage. If you borrow at 0% and lend at 2% - to buy Treasuries for example - you need the yen to remain stable or fall in value. If the yen rises 10%, that loss far outweighs the 2% you're making on the interest rate spread.

Often, the carry trade is a self-fulfilling prophecy, at least for awhile. The low interest rates cause people to bet against the currency and drive down its value. Other market participants are moved to take the same trade, since it's working and has momentum. At some point though, things get overdone, and the pendulum reverses. The yen, having devalued more than 50% in recent years, may have reached that point.

Now the yen is spiking higher. This causes great pain to the carry trade crowd, who is watching months of accumulated gains disappear with each passing week. The end result of all this will likely be an unwinding of the carry trade. People will sell the assets they bought with borrowed yen.

Normally a rising yen causes severe strain to the US stock market. So far, this hasn't yet occurred in recent weeks. But it's something to monitor. The rising yen is certainly causing strain on leveraged traders somewhere out there, and you'll see that effect cause a drop in liquidity here sooner or later.

Disclosure: I am/we are long CAT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.