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Most investors are aware that Abenomics is having an effect on global equity markets, but the extent of the connection is truly remarkable. In statistical terms the yen and S&P 500 are moving in exact lock step, and the leveraged yen carry trade, a staple among hedge funds globally, goes a long way toward explaining it. The trade also provides a partial explanation for the extreme levels of U.S. market volatility since mid-May.
A comparison of the daily performance of the S&P 500 and US$, Japanese yen exchange rate uncovers an R-squared so high – at 0.94 – that it's almost a waste of time to plot both lines on the chart.
Market prices across asset classes and in separate hemispheres are not supposed to move in tandem. The yen carry trade – although difficult to quantify – must be behind the trend.
In the lead-up to the official start of Abenomics, global hedge funds became certain that the massive stimulus plan would result in a weaker yen in U.S. dollar terms. En masse, they sold Japanese sovereign bonds short and used the proceeds to buy U.S. dollar assets, largely Treasury bills but also equities. Importantly, this trade was highly leveraged – a hedge fund need only hold $5-million as collateral for a $100-million short position.
The hedge funds' strategy was a success. Between November of 2012 and May 1 2013 the trade was remarkably profitable. The yen fell almost 30 per cent against the dollar which made the yen short position that much cheaper to cover (ie. to buy the Japanese government bonds back to close the short position).
The carry trade was a major positive driver of U.S. asset performance. In essence, money was being borrowed in Japan and poured into the U.S., pushing prices higher.
The problem came in May, when U.S. Federal Reserve Chairman Bernanke hinted that monetary stimulus may be withdrawn. The result was a sell-off in U.S. bond and equity markets.
Confronted with this new source of volatility, many of the highly leveraged hedge funds decided to back out of the yen carry trade – taking profits (selling U.S. assets) and closing the yen short positions (buying back the Japanese bonds). Again, measuring this is difficult, but the sharp reversal in the U.S. dollar to Japan yen exchange rate is a strong sign that it occurred.
I'm not suggesting that the carry trade is the only factor driving U.S. equity markets. But the insanely high correlation does suggest that yen and S&P 500 performance are extremely interconnected at the present.
The hedge fund sector's belief in Abenomics will, in the short term, determine where U.S. markets go from here. A resumption of the stronger dollar, weaker yen trend will likely see the funds put the carry trade back on. This would push U.S markets higher.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
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Scott Barlow