The carry trade – is this it?

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Market sentiment did an about-turn last week as uncertainty mounted on the back of the credit situation going from bad to worse. The upshot of the deteriorating outlook was a reassessment of risk by market participants as evidenced by a number of measures such as the Volatility Index (VIX) and the CBOE Put/Call Ratio pointing to complacency making way for fear.

But nowhere is it illustrated more vividly than by the continued appreciation of the Japanese yen as investors unwind their carry trades. The carry trade involved borrowing cheaply at low Japanese interest rates and reinvesting in high-yielding assets. The unwinding of the carry trade is putting downward pressure on high-yielding currencies such as the Australian dollar and the British pound and is furthermore leading to the liquidation of stocks across a broad spectrum. The latter phenomenon is clearly shown by the strong inverse relationship between the Japanese Yen Index (blue line) and the Dow Jones World Stock Index (red line) in the following graph:

carry-trade.jpg

Source: StockCharts.com

A further strengthening of the Japanese yen, on top of a barrage of other slumping economic and market factors, could spell bad news for financial markets in general. In short, this week promises to be a key week for financial markets and investors should exercise extreme caution.

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4 comments to The carry trade – is this it?

  • Louise Hill

    I recently started reading your work. Thank you.

    Things are not looking good here in Seattle and surrounding areas.

    I will be in touch.

    Louise

  • william

    Does this mean I should hold my AUSSIE $ or dump the FXA?

  • stevo

    Descending triangle formation in the SPX indicates that a break below 1450 to around 1430 is imminent. Below 1425 is bear market.

  • Thanks for the good work, Mr. du Plessis.

    An observation: The Yen DJI inverse relationship is clear. However, what also seems clear from the time period in the chart you show, is that both the DJI and the Yen are trending upwards.

    Questions: 1. How do you interpret this?

    2. You tend to highlight the bearish case. Here is my view:

    I expect the NASDAQ 100 to continue out-performing earnings expectations, through 2008. I also expect select Dow large caps (BA and MSFT for instance) to do quite well – just as I see the consumer getting increasingly pinched, housing falling apart, and the credit crisis continuing. What’s your outlook on this?

    By the way, I respect your work and link to it on my site.

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