Global stock market indices, including the major US indices, have had a violent shakeout in recent weeks. Will the global bull market continue? Or does the recent surge of volatility suggest the run is over?
It’s obviously a critical question for all investors.
The impressive gains the markets made this week have market participants and the media breathing a sigh of relief that last week’s volatility was just an overdue market tantrum.
“The markets were just blowing off some steam. Don’t worry about it. It’s nothing.”
We’re not quite so complacent. We believe that serious damage was done from the recent volatility and that investors should remain extra vigilant against further trouble ahead.
In fact, one of our favorite market “tells” quietly flashed a warning sign this week while everyone was popping corks at this week’s gains.
Our market tell is none other than the Japanese yen, which you can easily monitor via FXY, the Currency Shares Japanese Yen ETF. A strong yen could be big trouble for the financial status quo, and we saw very solid strengthening in the yen this week.
Why the yen? Because the Japanese yen is seen as a “safe haven” currency. When global markets tilt towards fear rather than greed, the yen tends to get stronger. When global markets are optimistic and calm, on the other hand, the yen tends to get weaker.
This phenomenon is related to capital flows from Japanese investors. In “risk-off” periods when fear rises, Japanese investors withdraw their capital from investments abroad. As that money returns home, it gets converted back into yen from other currencies and pushes the value of the yen higher.
It also has to do with something called the “carry trade.” For investors outside Japan, the carry trade involves the following steps:
- Go long Japanese stocks
- Short the Japanese yen to hedge currency risk
This “carry trade” is so popular there is an ETF devoted to it. You can buy DXJ, the Wisdom Tree Japan Hedged Equity Fund, which goes long on Japanese stocks and shorts the yen automatically.
Sophisticated carry trade investors go even further. They will borrow money in Japanese yen (at very low interest rates)… and invest that money in Japanese stocks. This also involves shorting the currency.
The simple takeaway from the above is:
- When global markets are optimistic, the yen tends to fall.
- When global markets are fearful, the yen tends to strengthen.
The strength comes from Japanese investment capital returning to Japan as fear rises, along with the “unwinding” of the yen carry trade, as investors outside of Japan sell their Japanese stock holdings and cover (buy back) their yen short positions.
And believe me, there is big money in the yen carry trade today.
That is why the strength we saw in the Japanese yen this week could be a major concern. Let’s take a look at what happened and what our indicators say about what the future might hold.
First off, you can easily see in the chart of FXY below that the yen broke very solidly up and out from nearly 18 months of price consolidation. The move up above 89 was very decisive.
Our cycle indicators and commitment of trader reports also point to a potentially stronger Japanese yen.
The chart below compares significant bottoms in the Japanese yen with time periods where commercial players – the “smart money” in futures trading – are significantly net long.
As you can see from the chart, the commercials are once again heavily net long yen futures… which suggests the yen could rise further from here.
So, while markets were staging an impressive rebound this week, the Japanese yen was surging to 18-month highs. The smart money also seems to be betting on a higher yen.
A lot of money that’s in the market today is there on a hair trigger. Everyone feels like they’ve got to be in the market … but no one wants to be the last out of the exits when the music stops.
If the yen continues to surge higher, the unwinding of the carry trade could be one of those events that unexpectedly sends the markets into a feedback-loop-induced tailspin.
Keep an eye on FXY. It could be the canary in the coalmine.
Richard Smith, PhD
CEO & Founder, TradeStops