Equity Markets and the Yen Currency

Below is a graph showing the correlations over the past year or so between equity markets (S&P 500, MSCI World and MSCI Small Cap) and the Yen/Euro exchange rate. Notice the late Febuary sell-off where all markets corrected and the Yen rallied by the same magnitude versus the Euro. To me this shows how much equity markets and global liquidity are potentially being impacted by the Yen Carry Trade.
















Source: Bloomberg


The Yen Carry Trade is the process where a speculator borrows in Yen (as costs to borrow in Japan are tremendously low --- reflecting the Japanese economy) and then takes those borrowings and buys higher yielding securities (say New Zealand Bonds) elsewhere by capturing the spread. These speculators will also use leverage to enhance those spread returns. Now should the Yen currency rally significantly then those borrowings cost more to the speculator, in essence hurting the returns (particularly given the leverage employed).

No one can really be certain how much money is involved but given the magnitude of the speculation out there generally, one can surmise that the numbers are big. The chart above can also act as proof of the potential magnitude given the close correlations.

Well, one could justifiably ask: "Why are you telling us this on a blog about compounding investment returns?" The answer is that one who acts as a speculator usually gets speculator-type results and those usually aren't pleasant ones. So be careful out there and only invest in things you understand and use minimal leverage. As the famous Keynes said: "Markets can remain irrational longer than you can remain solvent."