Tuesday January 15, 2008 - 12:56:14 GMT
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Black Swan Capital - www.blackswantrading.com
Higher Volatility Points towards a Stronger Yen
FX Trading â€“ Higher Volatility Points towards a Stronger Yen
Volatility is the enemy of the carry-trade. To prove that point, Japanâ€™s economy now seems to be fading fast, while the Japanese yen undergoes a substantial rally versus most other major currencies.
Keep in mind when you think of the carry trade, it can be any currency playing the role of the funding currency; it happens to be the yen has been the best for this, because until recently it met all three major criteria for a successful carry trade currency; they include:
1. Low borrowing rates; thank you Bank of Japan
2. Low volatility or weakness in funding currency i.e. the yen in this case
3. Low volatility or strength in invested asset class i.e. where you place borrowed money from the carry trade.
There seems a fairly tight correlation between bad news in the Japanese economy and good news for the yen. When Japanâ€™s economy looked to be gaining steam investors sold yen because the global economy was chugging along with nary a care in the world; risk appetites outside, and INSIDE Japan were high. Conditions were calm and predictableâ€”low volatility, a slowly weakening yen, and global growth and rising asset markets as far as the eye could see; an ideal environment for borrowing on the cheap and investing in high-yield plays.
Nikkei vs. USDJPY Weekly showing a tight correlation between the yen and stock market:
[Chart not available in text format]
The key elements for a successful carry trade are disappearing in 2008.
The New Year has brought about increased volatility across the boardâ€”stocks, bonds, and currencies. Now, the yield differential earned in the carry trade is being offset by unexpected price action in exchange rates. No longer are investors betting down a one-way street.
Despite poor prospects for Japanâ€™s economy, investors are now buying up the yen. Most are doing so to make good on previous bets (closing positions) that the yen would continue to fall and high-yielders would continue to rise; this group includes both hedge funds scrambling for cash in order to reduce leverage and domestic Japanese investors and institutions whose risk appetites has swung to risk aversion on Japanâ€™s dimming economic prospects. A growing number of others are buying up the yen for pure spec on the expectations for it to rally against the U.S. dollar and high-yielding currencies. This is the way bottoms are often made.
The global economic data points thus far have gotten pretty ugly, and theyâ€™ve got investors scurrying around like chickens with their heads cut off. A European report overnight showed that German investor confidence dropped to its lowest level in 15 years. A plateful of U.S. data out later this morning has the potential to be just as ugly.
To Sydney J. Harrisâ€™ point in the Quoteable today, carry traders dented the wall pretty good. But now that volatility has emerged and theyâ€™re starting to reach for the Aspirin.
[Chart not available in text format]
John Ross Crooks III
Black Swan Capital
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