Yen Carry Trade
Click to Enlarge Finally, let’s go back to what happened on Friday.
Stocks have been supported over the last few years by the popularity — especially among hedge fund types and other institutional traders — of currency carry trades. This is where people would short a weak currency like the yen, then buy assets in a rising currency like the euro. This explains why the Spanish five-year bond yield dropped below the five-year U.S. Treasury note yield last week.
On Friday, carry trades got hit hard by rumors out of the German press that the European Central Bank was modeling the market impact of a 1 trillion-euro bond-buying stimulus program. They wanted to see if it would reverse the slide in inflation and credit growth that is plaguing Europe at the moment.
While on the surface, this would appear to be good news for the bulls (more cheap money!) it pinched yen carry trade positions that relied on a relatively more aggressive Bank of Japan and a more stringent ECB; which, in turn, would result in a steady drop in the value of the Japanese yen against the euro.
The possible shift in the relative policy stances of these two major central banks upset these pair trades, forcing hedge fund types to scramble to close their positions by selling stocks and other risky assets, selling euros and buying yen. That, in turn, worsened the moves for others with the same exposure. Selling begat more selling.
Another factor has been the rise of damaging food and fuel price inflation in Japan, which is hurting consumer confidence and is a nasty side effect of the currency devaluation strategy being used — as a last-gasp effort — by policymakers in Tokyo trying to reverse the country’s decades long stagnation.
That decreases the odds that the Bank of Japan will look to weaken the yen with more stimulus in the near term. At this point, the cheap money is becoming counterproductive.
A similar dynamic with yen carry trades played out in the market’s rush to the last bull market peak in 2007.
How to Play It
In response, I’m recommending clients move into safe haven assets like U.S. Treasury bonds and the CBOE Volatility Index (VIX) for production. Highlights in the Edge Letter Sample Portfolio include the Direxion 3x Treasury Bond Bull (TMF). For the more aggressive, I’ve also recommended put option positions against big tech stocks like Facebook. The April 65 puts I recommended on March 21 are up nearly 400% since then.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TMF and FB puts to his clients.