The Yen Carry Still Matters

Stock Market Vulnerability

Stock market investors who spend an excess of their waking moments worrying about the Fed's next move in the mistaken assumption that rate cuts mean good and rate hikes mean bad should be asking themselves whether their domestic misunderstanding has a valid passport.

It does.

We can map the average annual returns of the countries in our data sample against the average annual total return for the yen carry, spot rate return plus interest rate spread return.

Even if we isolate the obvious outliers of Turkey and Argentina, the positive relationship between stock market returns in dollar terms and total return on the yen carry trade is both visually apparent and statistically demonstrable; the regression beta is 1.776.

Positive Correlation Between Yen Carry and Equities

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Sources: Data from Bloomberg, calculations by Simons

The comparable regression betas for the two components -- the interest rate spread and the spot rate -- are quite different. In the spot rate case, we have a nondeterministic relationship with a beta of -0.03, excluding Turkey and Argentina. This should lead us to suspect it is the interest rate spread component that drives the relationship between stock market returns and the yen carry trade. Here the regression beta is 1.03, once again excluding Turkey and Argentina.

Rates and Capital Flows

The connection is clear: The high rates of emerging markets attract capital from low-rate countries such as Japan. These capital inflows not only support the various currencies but also support the various equity markets. The world got a taste of what a rate and liquidity shock from Japan could look like last May-June, and in a grander scale it got a similar shock 10 years ago this coming July, with the Thai baht devaluation and the onset of the Asian crisis.

Short-term rates will have to rise further and faster in Japan someday, a statement that has been as routinely unsuccessful for the past decade as a forecast of the sun rising in the west. When those rates rise, countries whose currencies and markets have depended on cheap and readily available capital will have to adjust. This adjustment need not be a disaster; after all, China alone has $1 trillion in foreign exchange reserves that can be lent to whomever, and it is in no one's interest to see a repeat of the Asian crisis on any scale.

The key will be how well the Bank of Japan communicates its intentions to the market and whether it can be more adroit this time than it was in the spring of 2006. This is a tall order and will go a long way toward determining how fast 2007 goes by in our minds.