The Link to Emerging Markets

Let's take the case of emerging markets, which until the recent tumble had been on a tear. If we map the course of an ETF linked to the Morgan Stanley Emerging Markets Free index, the iShares MSCI Emerging Markets (EEM - commentary - Cramer's Take), against the yen, we see a very clear leading relationship.

The yen leads the EEM by one month on average.

As the currency continues to strengthen, we can surmise yen carry traders will close their emerging-markets positions and drive these indices lower.

These engines of global economic growth are threatened, clearly and directly, by the BOJ's policies.

Yen Strengthened in Advance of Emerging Markets Break

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Source: Bloomberg, Howard Simons

The Yen-Yuan Connection

I first discussed the impact of the cross-rate between the yen and the yuan on U.S. bonds in April 2006. The mechanism was straightforward: As the yen strengthened against the yuan, Japan felt it needed to restore its competitiveness by driving the yen lower by printing yen and selling them for American bonds.

That was a strong and demonstrable relationship. However, it is nowhere near as strong as the relationship between the yen-yuan cross-rate and the total return on U.S. stocks as measured by the Russell 3000 index. As the yen strengthens on the cross, U.S. stocks drive lower. Once again, the BOJ's policies are producing financial stress.

U.S. Stocks' Asian Currency Connection

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Source: Bloomberg, Howard Simons

The Light at the End of the Tunnel

The picture so far has been pretty gloomy. Is there a win-win solution somewhere? Yes, and the answer is China. Our good friends in Beijing have $1.332 trillion in foreign exchange reserves and they have customers on this side of the Pacific who keep their factories humming and churning out all manner of wonderful products, none of which you should ingest without a Royal Taster by your side.

By the way, how much is $1.332 trillion? If you had spent $1.8 million per day every day since the year 1, you would not have spent $1.332 trillion yet. It is a lot of money.

According to data compiled by the U.S. Treasury, China has been recycling its reserves into the U.S. primarily through purchases of Treasuries and Agencies, and to a lesser extent corporate bonds. However, in June, the last reporting month, China's purchases of U.S. stocks shot higher.

Are China's Buying Habits Changing?

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Source: U.S. Treasury, Howard Simons