The Yen Loves Misery

Global equity markets are crashing. Credit markets have seized up. Infinite injections of liquidity have failed to turn the tide. Global interest rate cuts are expected, but even if rates were to be cut to zero, there is no guarantee that banks will begin to lend freely to one another. They say that it is darkest before the dawn, but if that is true, then why is there, seemingly, no end in sight?

In the midst of all this market misery, there is a winner – a beneficiary that thrives on market mayhem and credit chaos. I’m speaking of the Japanese Yen, one of two currencies (the other one is the U.S. Dollar) that have actually gained strength as the world around them seems to collapse.

This relationship between world equity markets and the Yen is not new; in fact, we discussed it at length in a previous article, titled It’s a Free Market or It Isn’t. What savvy traders learned was to short the JPY vs. weak currencies like the British Pound during tumultuous times. Well, that relationship is holding true, as another selloff in the S&P 500 is being matched by and equally precipitous drop in the GBP/JPY currency pair. Here is an intra-day look at the daily chart of the S&P E-minis (see figure 1).

Figure 1. S&P 500 drops sharply intra-day on October 6, 2008. Source: Saxo Bank

Now let’s look at a chart of GBP/JPY taken at approximately the same time. You’ll notice that the charts are not exactly the same, but do mirror each other rather closely (see figure 2).

Figure 2: GBP/JPY falls off of a cliff on October 6, 2008. Source: Saxo Bank

Why does the Yen do so well when the rest of the world is feeling the heat? Because of the Bank of Japan’s low interest rates, the Yen is often used as a funding currency for the carry trade. This is a trade that benefits from stability in global interest rates, and consists of shorting the Japanese Yen against higher yielding currencies. So, traders short the Yen (and buy stocks) when they are willing to take on risk. However, the current environment is risk-averse, meaning that traders are selling stocks – and abandoning carry trades. When traders close the carry trade, they are actually short-covering the Yen. So, when risk aversion takes over, that is when stocks fall and the Yen rises – hence the strong relationship between the Yen and global equity markets.

Ed Ponsi is the President of www.FXEducator.com and www.EdPonsi.com. He has appeared on CNN, CNBC, the BBC and Fox Business News, and is a frequent guest lecturer at trading events and seminars around the world. Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ponsi is featured on the FXEducator.com DVD series, Forex Trading with Ed Ponsi, and is the author of the best-selling book Forex Patterns and Probabilities.