With Market Jitters, The Yen's Increase Will Likely Continue

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Includes: FXY, JYN, UDN, USDU, UUP, YCL, YCS
by: D. H. Taylor

Summary

Interest rate differentials are narrowing between Japan and the Untied States.

Market jitters are pushing individuals out of the carry trade.

Future volatility with a stock market sell off will continue to push yen higher.

The yen has been gaining on the USD. There is reason for jitteriness in the markets and when that happens, yield-hungry Japanese investors get out of their higher yielding currencies and repatriate their funds back home to Japan. The United States 10-year yield has dropped from 2.60% just three weeks ago when the Federal Reserve was raising interest rates to 2.30% today. That drop in yield, and what is likely to be a far more sustained drop in rates in the United States is going to narrow the interest rate differential significantly. The Japanese yen is very likely to rally over the next month from this level of 110.25 USDJPY.

I have become significantly bearish on the United States equity market in very short order. The failure of the Republican Party to push through something they have been chomping at the bit over for some 8 years is going to be disastrous to the markets in so many ways. The most significant is when the equity market corrects from its blistering run upward from 17,750 - 21,250 in just five months.

The interest rate differential, when considering FX trading, is the difference between interest rates in one country versus another country. In the United States versus Japan, the yield on the 10-year government bond is 2.35% versus 0.07%, respectively. In essence, you can borrow money in Japan at a rate similar to the government bond of 0.07%. Then, you can deposit the funds you borrowed in Japan into an instrument in the United States for 2.35%. The difference, or, the differential, in this example is the 2.28%. You would earn that differential.

FX traders do this all the time. You are paid an amount similar to this differential every day for holding a long high-yielding currency versus a lower yielding currency.

But, if interest rates start moving, and the differential narrows, the trade falls apart. You would sell the USDJPY. As it is, the yen has been rallying the past several weeks since the drop in the U.S. interest rates.

Here is a look at how the interest rates have been narrowing from the United States versus Japan:

If the 2.30% level drops in the yield in the United States, USDJPY will fall significantly. The trigger for this would be simply continued disappointment in what the stock market has already priced into their Price/Earnings ratio. If the stock market sells off significantly, you can expect the differential to narrow very quickly and FX traders will be selling USDJPY en masse.

I have said this a few times, I see no ability for the Republican Party and the current administration to cohesively put together any meaningful legislation that will continue to keep the stock market at such lofty levels. On that, I am not alone. Those numbers will continue to increase as every day passes and nothing meaningful happens with the government.

The interest rate differential will continue to narrow as the market continues to sell off. JPY will continue to move higher. Couple this with a few other countries around the world missing on some notes, such as the Australia's currency dipping on the RBA not raising interest rates and you can sell the carry trade and be very profitable.

There are a number of factors that could push the interest rate levels higher in the Untied States. A sell off in the Dow is very probable. And, then there is the potential of Le Pen winning the French election and all of a sudden you are calling in to question the chances of another referendum on the EU. There is a lot of reason to not be involved in investments that are bound to stability in the financial world, such as the carry trade. We are already seeing this play out in the JPY.

I no longer have long positions in the carry trade. I am looking to build up positions going short USDJPY and put in other positions such as a larger long gold to take advantage of the markets uncertainty and the potential of selling that is ahead.

Disclosure: I am/we are short AUDJPY.

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.