All kinds of indicators provide clues to the future direction of the capital markets. But I have one “Look Out Below” indicator that practically trumps them all.
I’m talking about the Japanese yen. When it starts surging in value, you better buckle up — because that kind of move can signal that a massive bout of volatility and large stock market losses are headed your way.
Why? It goes back to the implosion of large-scale, global “carry trades” funded by cheap, easy money.
You might remember my piece on these trades from August. But just in case you missed it, a carry trade is when you borrow money from one cheap, low-rate source of funds. Then you turn around and invest that money in more expensive, higher-rate assets. Your profit is the difference between what your funds cost to borrow and what you earn from your investments.
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The $5.3 trillion currency market is famous for this. Investors worldwide are constantly borrowing in the cheapest currencies they can find, and investing those funds in higher-yielding ones. They use massive amounts of leverage – even 100-to-1 or more — to increase their returns. And they count on making money from both moves in underlying currencies, and the increasing value of the assets they buy with their borrowed money.
But if the assets you bought start falling, you lose money.
If the currency in which those assets are denominated falls, while the currency in which you borrowed your funds rises, you lose more money.
And if you’re leveraged 50-to-1 or (gasp) 100-to-1? Good night!
|If the yen breaks out sharply, there could be heck to pay in other markets.|
The yen is notorious for serving as a carry-trade funding currency because Japan has had rock-bottom interest rates and massive QE programs in place for years. No one knows the exact size of these carry trades. But we’re likely talking about several hundred billion dollars, at least.
That brings me to the recent action in the currency market. Bank of Japan Governor Haruhiko Kuroda tried to drive the yen sharply lower a week ago, with the aim of spurring economic growth and inflation. Never mind that the devaluation policies Japan has pursued since 2012 haven’t worked. Kuroda said this latest move would.
But after sharply falling for one day, the yen bottomed … stabilized … and then absolutely exploded higher on Wednesday. It was a complete, total, absolute invalidation of Kuroda’s policy, and it tells me that currency market players are running scared.
Now take a look at this chart …
You can see the yen has been bottoming out for the better part of a year and a half. If the currency breaks above the 86 level, it will likely be accompanied by a large surge in market volatility. We could also see a major move lower in stocks, and particularly acute pain in credit-sensitive equities like banks, brokers, insurers, and real estate companies.
My advice? Watch this “Look Out Below” indicator closely. If it breaks out sharply, there could be heck to pay in other markets. And even if it doesn’t do so right away, the volatility surge we’ve seen across the board confirms that playing defense and staying cautious is the best investment approach right now.
Until next time,
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