Friday, February 16, 2007

Is the Carry Trade Carrying the Stock Market?

When my wife and I bought our new house in Fayetteville, NY, we originally planned to make the purchase outright. We heard, however, of an adjustable rate mortgage with a very low initial teaser rate, no points, and no prepayment penalty. So we took out the mortgage, paid a couple points of interest, and kept our money in high yielding CDs for that year. Altogether we netted about 5% on our money with no downside risk.

Little did we know it back then, but we were engaging in a version of the "carry trade" now popular among institutional investors. Japan is acting as the generous world bank, offering money at very low interest rates. This enables investors to borrow Yen and invest money in the higher yielding debt markets, such as those of New Zealand. Those investors net several percent return essentially risk free.

An excellent summary of the carry trade is provided by Michael Shedlock, aka Mish. He reports, "The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash."

This free cash has also encouraged riskier trading. After all, if I can go to my local bank and get very low interest loans, I can participate in the stock and commodity markets and pay very little for this new source of margin debt. This dynamic has helped lift multiple markets simultaneously, as we've had bull markets in equities, commodities, and fixed income markets.

An interesting view of the impact of the carry trade can be obtained by examining the relationship between the Yen/Dollar and the S&P 500 Index (both cash markets). Let's see what happens in stocks when the Yen is weak vs. strong.

Going back to 2003 (N = 1017 trading days), we have 380 occasions in which the Yen has been above its 10, 20, and 40 day moving averages. Twenty days following such Yen strength, the S&P 500 Index has been down by an average of -.40% (153 up, 227 down). A strong Yen has not been kind to stocks, perhaps because--reflecting interest rate firmness in Japan--it is associated with a more expensive carry trade.

Conversely, since 2003, we've had 394 occasions in which the Yen has been below its 10, 20, and 40 day moving averages. Twenty days later, the S&P 500 Index has been up by an average of .44% (222 up, 172 down). Returns have been more favorable following periods of weak vs. strong Yen, as we'd expect from the carry trade.

Since 2005, a strong Yen has been especially toxic for stocks. When the Yen has been above its three moving averages (N = 125), the next 20 days in the S&P 500 cash index have averaged a decline of -1.30% (34 up, 91 down). That is an amazingly negative performance during a bullish market period. Interestingly, however, weak Yen periods since 2005 have not been associated with the bullish edge that they possessed in 2003 and 2004. Indeed, 20 days following periods of Yen weakness, stocks have averaged a loss of -.15% (119 up, 146 down).

What this might suggest is that the U.S. equity market is obtaining diminishing returns from the carry trade. Stated otherwise, stocks might be growing more sensitive to an unwinding of the carry trade (via stronger Yen and higher rates in Japan) than to further Yen weakness. If that is the case, the carry trade may have more potential to carry us lower than higher.

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