Appreciating Yen Could Cause Trouble For Equity Markets

Regarding the stock market's run-up, a great deal of credit has been given to merger mania. What's more, some predict that when the buying frenzy dries up, the stock market will drop precipitously. However, some attention might be given to the so-titled "yen carry trade."

This refers to the practice of borrowing the Japanese currency at a very inexpensive rate (0.5%) and investing in high yielding instruments of other countries. Many invest in the US currency (5.25%), British pound or New Zealand dollar (8.0%).

Of course, borrowing in yen makes it easy for some companies to buy other companies as well, making many of the buyouts possible. What's more, investors can also borrow or short the yen to invest in all kinds of assets.

This begs the question: Have the stock markets around the world been propped up by the carry trade phenomenon? It's difficult to give any other answer than, "Yes."

For instance, there's a perfect correlation between the April 2006 quasi-correction/international sell-off and an appreciating yen. Moreover, the China scare in late February 2007 had been accompanied by fears of the carry trade falling apart as well.

Roger Nusbaum points out that the PowerShares DB G10 Currency Harvest (DBV) is designed to harvest the differences between low-yielding currencies like the yen and high-yielding currencies like the Australian dollar. DBV is up 13.5% this year.

But what if the yen really did make a significant run? Certainly, the DBV would be in harm's way. Similarly, high-yielding currency ETFs like the Australian Dollar Trust (FXA) and high-yielding stock destinations like the iShares MSCI Australia Index (EWA) could be hit hard by a fast growing yen.

In an era where there's been a Japanese renaissance of economic growth, as well as expected policy hikes on Japanese rates, yen weakness may not last forever. The fear of an appreciating yen or the reality of an appreciating yen could truly cause trouble for the equity markets.

Panic time? Not really. Pundits have been calling for the death of stocks on everything from overvaluation to high oil prices to inflation to questionable corporate profits to the subprime lending crisis.

Nevertheless, there will come a day when money will leave stock assets. The smarter, more balanced investor will have a plan to lighten his/her exposure accordingly.

Disclosure Statement: As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.