Saturday, October 20, 2007

The Yen, the Australian Dollar, and Stocks

As you probably know, stock markets world wide experienced significant corrections yesterday. Many people blame this on the 20th anniversary of the 1987 stock market crash, but I think that it was quite clear that a correction was coming, no matter what the reason behind it.

In the last post, I said that gold stocks were looking weak, and right now I still feel that they are looking weak. Some of this weakness has to do with the fact that equities in general are declining, and gold stocks, being stocks, will continue to fall as the markets fall, as Paul mentioned in a comment in the previous post.

When times get tough, it is certainly better to be in the metal rather than in gold stocks. You know, gold actually rose about 11 dollars this week, and paradoxically, my short gold stocks position made over 5% this week.

Anyway, let's have a look at some of the intermarket forces at work that may be driving global stock market weakness.

The following chart shows the Japanese Yen divided by the Australian Dollar. This relationship helps illustrate the health of what is called the carry trade. This refers to when traders borrow Yen at low interest rates, and convert it into a higher yielding currency in order to make profits.

Some traders go a step further and invest the higher yielding currency into the stock market for additional profit potential. An example of this would be a trader borrowing Yen at a rate of interest of 0.5% and buying Australian Dollars, which yields 6.5%, for an easy 6% profit. The trader then may invest the money in Australian stocks.

Since the trader borrowed Yen he will have to pay it back. If the Yen remains flat or decreases, the trader will hold his position. However. if the Yen starts appreciating rapidly, the trader will be inclined to sell his Australian stocks, take his dollars, and convert them back into Yen, before it appreciates anymore.

The above chart shows the TSX in red, which is similar to the Australian Stock market, and as you can see, when the Yen increases relative to the Aussie, the carry trade unwinds, and the TSX plummets. What happens in the TSX is also experienced by other markets world wide.

This fact, that the yen increased sharply this week, is one of the main culprits to the recent stock market decline, in my opinion anyway.


Got A Watch said...

Sunday night - carry-trade un-winding in full effect it seems. From 116.6 or so Thursday night to around 114, moved as far as 113.3 or so Saturday. USDX poised to fall below 77? Interesting times, indeed.

BTW I am just commenting, I meant no criticism of your analysis or methods, I think I can safely say your level of expertise is far above my own.

I fully understand (from bitter personal experience, LOL) that many trades do not work out as planned - but it takes a professional attitude and strong nerves to not be affected by losses. Your outlook is the right one.

Danny Merkel said...

Hi there,

I was watching the markets on Sunday night as well, and felt the same way.

I said to myself that the stock markets and commodities were going to get hammered tomorrow if this keeps up.

The markets did in fact open down substantially, but made back most of their losses, and formed some short term bullish candles. But we are still, as you said, in interesting times.

I appreciate your comments, and feel free to comment in the future.