Putting The Euro-Yen Cross-Rate To Work

RealMoney readers know how to stalk their prey. Consider the following email selections from a frequent correspondent:

It has been about two months since your conspiracy thoughts were floated up re: the yuan and about five months since "the new regime" started." During that five-month period, it would appear we have about 1%-2% movement in the yuan/dollar, with a center of gravity around 6.82 yuan/dollar. Out of the 25+ currencies I follow from a distance, I could find no other examples of such calm against the dollar.

Hopefully, the questions are interesting enough to spark a column sometime in the future?

What could I do when faced with such a challenge? Just like former Kansas City Royals third baseman George Brett when accosted by Morganna the Kissing Bandit, I was surrounded. But rather than revisit the exact topic of that September column directly, I thought it would be best to visit a related trade first -- the euro-yen cross-rate -- and then update a January column on the yuan next week.

The Euro-Yen Cross-Rate

The euro-yen cross, expressed as yen per euro, is an excellent barometer of the world's appetite for risk. When the yen is weakening against the euro, yen carry trades, last visited here in September 2007, are open and money is flowing out of Japan in search of higher returns elsewhere. When the yen is strengthening, as it has been in recent months, the exact opposite situation applies: Risky assets are being sold.

Yen per Euro High-Low-Close Volatility Surged During Rally

Click here for larger image.

Source: Bloomberg

Volatility Indicators

A key date in the history of the euro-yen is July 15, 2008, when Fannie Mae (FNM - commentary - Cramer's Take) and Freddie Mac (FRE - commentary - Cramer's Take) were de facto nationalized by the U.S. government and when the yuan stopped rising; this date is marked with a green vertical line below.

Two aspects of the trade changed and changed drastically. First, the yen shot higher. Second, the high-low-close volatility of the cross-rate, a measure that accounts for intraday range as well as interday change, shot higher as well. This was the tipoff the world's risk appetite was disappearing.

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Short-Term Expectations Are not a Major Factor in Cross-Rate

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Source: Bloomberg

Short-Term Interest Rate Expectations

Now let's turn to the issue of relative short-term interest rate expectations. We will use the forward rate ratio between six- and nine-month LIBOR (FRR6,9) -- the rate at which we can lock in borrowing for three months starting six months from now -- divided by the nine-month rate itself as our metric. The more the FRR6,9 exceeds 1.00, the higher those three-month rates are expected to be six months from now.

The difference between two FRR6,9 numbers gives us the relative rate at which two short-term interest rates are expected to move over that horizon. In a normal relationship, the higher the differential between currencies X and Y, the more currency X is expected to rise relative to currency Y.

Here the relationship is interesting. The JPY has had a persistently high FRR6,9 for years, as few have believed its minuscule interest rates could persist. The same can be said now for the U.S. dollar. The persistent bias means we have to look more at the trend of any JPY FRR differential as a result.

Two observations are offered. First, the FRR differential leads the movement of the cross-rate by 10 weeks on average. Second, nothing in its course during 2008 signaled the explosive increase in the cross-rate. This means the euro-yen cross is being driven by factors other than short-term interest rate expectations.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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