Tuesday, July 20, 2010

The Dynamic Relationship Between Global Equity Markets and Japanese Yen

Guest post by  Vincenzo Deroches

During the late 1980’s and early 1990’s, Japan experienced a severe slowdown in economic growth.  Although there were many factors at work causing the financial meltdown, a major cause was an asset bubble that had burst in Japan.  Japanese equity and real estate markets were growing at unprecedented rates throughout the 1980’s until the bubble burst.  And when it burst, it burst!  A period of financial distress began to develop in Japan that has become known in the financial world as “The Lost Decade.”  Although the exact details of the Crisis are beyond the scope of this article, the one important fact is that, in hopes of revitalizing an anemic economy, the Bank of Japan eventually lowered interest rates significantly, and they have held interest rates at close to 0% since then.  This single fact, that the Bank of Japan has set its short-term interest rate target at 0% for many years, has caused a fascinating correlation to develop between the Japanese Yen and global equity markets.

The primary goal of every fund manager in the world is to produce a positive return for the year.  In order to do this, traders and investors must find yield.  This is where the Japanese Yen comes into play.  Does the Japanese Yen offer much yield?  Of course not.  Interest rates are near 0%.  If you invest in something and earn 0%, you aren’t making much money, right?  Thus, investors are not interested in investing in the Japanese Yen necessarily.  However, they are interested in taking out loans in Japanese Yen, and then investing that capital in higher yielding assets, such as global equity markets, venture capital opportunities, real estate markets, etc.  Since they are paying virtually no interest on their loan, they can then take that money and put it to work in other markets.  Consequently, the standard relationship between the equity markets and the Japanese Yen is—when equity markets are rising, and investors are willing to take risk, the Yen tends to fall significantly in forex market trading as investors are selling it.  Let’s take a look at a chart


This chart depicts the massive weakening of the Yen from 1999-2007, as investors sought higher yield.  But the Yen doesn’t weaken forever!  When equity markets begin to fall, and global economic concerns grip the market, the Yen tends to outperform every currency because all the investors that borrowed Yen at 0% interest rates in order to invest in higher yielding, risky investments, are now repatriating their investments back into the Yen, so that they can pay back those loans, and get their cash into safe investments.  Let’s take a look at another chart.

This is what happens in times of economic uncertainty.  The Japanese Yen gets extremely strong.  This is problematic for the Japanese economy because they are an export-based economy, and a strong currency makes their exports much less attractive to foreign nations.  The next time the global economy threatens to unwind, consider positioning yourself for profit by buying the Japanese Yen.