Falling U.S. Rates And The Stock Market

Summary

The Fed has recently announced that it does not envision further rate hikes in 2019, and it opted to keep rates unchanged.

Weaker U.S. rates sentiment has already affected bond markets, and changing yields directly affect how favorable or non-favorable carry trades are, such as the popular USD/JPY carry trade.

Although USD/JPY has struggled recently, it has not been quite as responsive as the adverse change to the underlying interest rate differential.

It is the author's opinion that while divergences can persist, USD/JPY is probably likely to struggle to gain upside traction, and this could also indirectly put pressure on the prices of U.S. equities in the short-to-medium term.

U.S. equities are starting to get pricier in terms of other major foreign currencies (such as euros and pound sterling), and in combination with falling carry trade sentiment, this could soon spell difficulty for U.S. stocks.

Interest rates matter, especially to carry trades. Indeed, interest rate differentials are what determine which currency pairs are positive-carry or negative-carry. If you can purchase one currency that yields "X" in terms of another currency that yields "Y", so long as X exceeds Y (after costs) you make money. In the reverse situation, you lose money (since the differential would be negative).

Of course, interest rates are important for other reasons beyond carry trades. But interest rates, especially as they relate to carry trades, are important for U.S. stocks too. Modern financial markets, like the one for U.S. stocks, are undeniably global, and as a result, foreign currencies can affect prices and, therefore, the demand of traditionally dollar-denominated assets internationally.

Therefore, if currencies matter and interest rates are the primary driver for currencies over the long term, then interest rates are important to monitor. Admittedly, herein lies an assumption that interest rates are the primary driver; other factors such as purchasing power parity, not to forget basic economic indicators such as inflation and unemployment, are all important too.

But interest rates are extremely important, as they provide clear-cut directional bias through financial incentives for currency traders.

This leads us to the risk-on and risk-off concepts. Risk-on currency pairs are generally (though not necessarily) those currency pairs which are positive-carry. Perhaps the most important is the dollar-yen (USD/JPY) pair. If you can borrow in Japanese yen at cost Y and use those yen to buy U.S. dollars that yield X, you make money (provided that difference provides a net positive interest rate differential).

But carry trades are not just used to gamble on currencies in isolation; the currency that is purchased is often used to acquire assets in such newly purchased currency. Hence, positive-carry pairs like USD/JPY tend to (though again, they do not always) correlate positively with "risk" assets like U.S. equities.

A chart below illustrates the yield differential between U.S. two-year treasuries and Japanese two-year treasuries (a proxy for the interest rate differential). The (weekly) black-and-white candlesticks illustrate USD/JPY, while the green line depicts the interest rate differential. For good measure, the red line is included to depict the S&P 500 (a popular U.S. equity index).

USD/JPY Yield

(Chart created by author using free charting tools provided by TradingView.com. The same applies to all other charts presented hereafter.)

As one might expect, there is much variation on all time frames. However, traders should maintain caution at this current juncture. As we can see, despite rising U.S. stocks recently (demonstrated by the red line rising most recently in the above chart), the yield differential between the important USD/JPY pair (see green line) is falling.

As recently reported, the U.S. Federal Reserve (central bank) has announced that it does not wish to raise rates in 2019, voting unanimously on March 20, 2019, to "to maintain its benchmark interest rate in a range of 2.25 percent and 2.5 percent" and updating "their economic projections, trimming the number of increases they foresee in 2019 from two to zero".

This is an important change, and with the aforementioned USD/JPY interest rate differential already changing significantly, the author believes that this has unlikely "fed into" (if you will pardon the pun) all markets, including U.S. equity prices. While the yield between U.S. dollars and Japanese yen is still safely positive, weaker sentiment certainly warrants caution, especially since carry trades often depend on large, leveraged borrowings in the "short" currency (the one you sell, i.e., Japanese yen in this case).

The USD/JPY has clearly not performed well recently, although it is still higher than it was at the start of the year, when it dipped as low as 104.656 in an early New Year flash crash. Yet, at this point (of the flash crash low), the yield between U.S. and Japanese two-year treasuries was +2.53%. At the time of writing, the difference is modestly lower, yet at 110.85, the USD/JPY is safely higher than prices seen in January 2019 (in the 107-110 range).

A daily candlestick counterpart of the previous chart above is provided below, to illustrate more recent moves.

USD/JPY Changing Yield

As can be seen, despite yields dropping quickly and the USD/JPY pair struggling to gain traction, U.S. stocks are surging higher.

Divergences between carry trades and risk assets like U.S. equities can persist, not least because carry trades are not the only thing that matter. Yet, caution is still warranted. The less favorable the international differentials (in terms of both interest rates and prices), the more pressure is placed on the risk assets in question.

A final chart, shown below, is also interesting - it shows the S&P 500 index (the black-and-white daily candlesticks) against the same index but in terms of yen (red line), euros (orange line) and pound sterling (blue line). This chart merely illustrates how U.S. stocks can "look differently" (more or less expensive) in international terms as currencies move up and down.

U.S. Stocks in International FX

Currently, U.S. stocks do not look too pricey in Japanese yen terms (red line), helped by the struggling USD/JPY pair as of recent. But they do look more expensive if expressed in terms of euros or pound sterling (orange and blue lines).

With a changing (less favorable) sentiment on U.S. rates, and given that U.S. stocks are looking a bit more pricey in terms pound sterling and euros (two other major currencies), the author would prefer not to underestimate the potential for further USD/JPY outflows and, subsequently, U.S. equity outflows over the short-to-medium term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.