Is this It For the Carry Trade?

Market sentiment did an about-turn last week as uncertainty mounted on the back of the credit situation going from bad to worse. The upshot of the deteriorating outlook was a reassessment of risk by market participants as evidenced by a number of measures such as the Volatility Index (VIX), and the CBOE Put/Call Ratio pointing to complacency making way for fear.

But nowhere is it illustrated more vividly than by the continued appreciation of the Japanese yen as investors unwind their carry trades. The carry trade involved borrowing cheaply at low Japanese interest rates and re-investing in high-yielding assets. The unwinding of the carry trade is putting downward pressure on high-yielding currencies such as the Australian dollar and the British pound and is furthermore leading to the liquidation of stocks across a broad spectrum. The latter phenomenon is clearly shown by the strong inverse relationship between the Japanese Yen Index (blue line) and the Dow Jones World Stock Index (red line) in the following graph:

Source: StockCharts.com

A further strengthening of the Japanese yen, on top of a barrage of other slumping economic and market factors, could spell bad news for financial markets in general. In short, this week promises to be a key week for financial markets, and investors should exercise extreme caution.