Prospects for a resumption of the yen-based carry trade could help boost equities in the coming weeks, putting the uptrend from March lows in the major indexes back on course after recent pullbacks.
The carry trade involves borrowing a currency at a lower interest rate, and exchanging it for another currency in order to invest in markets that offer higher return potential. For example, yen can be borrowed at a comparatively low interest rate and exchanged to buy government bonds in New Zealand, where the base rate is attractive at 8.25%. The yen-based carry trade can also boost demand for global equities.
Since early 2005, the dollar/yen has advanced (translating to a weakening yen) on a path that pretty closely matches the rally in the S&P 500 index. Low interest rates in Japan and the weakening currency have made it attractive to borrow there and invest the proceeds in other markets, including U.S. equities. As long as the yen continues to weaken, and borrowing costs are stable, the amount required to pay back loans eventually becomes cheap.
The last near-term correction in U.S. stocks started on February 27, 2007. The drop was sparked by a big sell-off in China due to news of tighter trading regulations. But the decline was likely exacerbated by an unwinding of carry trades. The dollar/yen sank sharply on that day, which suggested institutions sold stocks and other assets around the world, and bought yen in order to repay the loans taken out to initiate carry trades.
Now, move forward to March 5. The dollar/yen established a bottom on that day and began an advance that lasted into late June. The S&P 500 formed a bottom on the same day that eventually ushered in a rally through mid-July.
Looking at recent market behavior, since June 22, the dollar/yen has fallen from a high of 124.13 to a low of 119.81, as the price found technical support around 120. Based on past price behavior, 120 represents a level of perceived value - a natural place to sell yen for U.S. dollars. It is also pretty close to a 50% retracement of the advance from March to June. It is common for the price to resume an uptrend after retracing 50% of the most recent upleg. This near-term decline should be placed into the context of the long-term uptrend from the start of 2005.
There is no technical evidence to indicate this move higher has been exhausted. An upturn in the dollar/yen after testing 120 could generate increased interest in carry trades, thus contributing to upside in U.S. stocks.
Essentially, borrowing yen at a higher value compared with a month ago and selling it in order to invest elsewhere becomes an attractive scenario.
Watch the dollar/yen in the coming days or weeks to see if technical support around 120 holds. If this level does hold and the currency pair turns up, start looking for signs of investment capital moving back into U.S. equities. The uptrend in the S&P 500 since March should stay sound unless technical support at about 1484 is breached. Readers should note, however, that history does not always repeat itself.