Why the recent violent gyrations?

Is "synthesized unwinding of yen-carry trades" the answer? (October 31, 2008)

The recent rapid fire giant gyrations of US stock markets are certain to make observers dizzy and disoriented. Investors large and small are watching helplessly the sever pounding on their portfolios with intermittent short reliefs of the pressure. Most investors are frozen on the track afraid of making any move. Readers of this website must be eager to know why such wild gyrations and when the bottom will be reached. We certainly share the same desire and are constantly looking for the answer. Our findings will be reported on this new series of discussion titled “US Stock Market” until the bottom of the bear market is reached. The first installation of this series should have been Comment 61 though it did not carry the title of "US Stock Market (1)". That is the reason why this comment carries the title "US Stock Market (2)".

Major financial media do not provide much help in our quest to entangle the mystery of the stock market as will be discussed later. We should understand that major financial media are by nature mouth pieces of Wall Street, but not objective analysts of the actual market. Wall Street makes money when investors are euphoric and enthusiastically buy stocks whereas rainy days of Wall Street descend when investors large and small are frozen from fear like in the present situation. That is why major financial media are always biased toward bullish sentiments and urge investors to buy stocks. To make matters worse many on Wall Street are Euro-centric. For example, when they talk about strong or weak Dollar, they always mean strong or weak Dollar versus Euro and nothing else. When they encounter something that they do not have an answer, they always point their finger toward Europe for good or bad, though the slow moving Europe has failed to play any leading role throughout the drama of repeatedly forming and bursting bubbles under this ad hoc globalization scheme, which has been pushed strongly by all the US administrations since the Reagan era as discussed in article 10. Besides the Euro-centric crowd there is also a China-centric crowd that forms the core of so called “decoupling theorists”. This China-centric crowd wishes that China will rise like the superman to combat the dragon of global financial loss, that may well run into tens of trillions of dollars, by wielding its meager 1.8 trillion dollars of foreign currency reserve. In the valley between the Euro-centric mirage and China-centric fantasy lies the key, that is, Japanese Yen, to our quest. Astute readers have probably noticed already that in the recent market gyrations US stock prices as a whole are closely connected with the movement of Yen-Dollar exchange rate. When US stocks fall, Dollar falls against Yen, and when US stocks rise, Dollar rises versus Yen. The Wall Street Journal online and Bloomberg.com carried the simplistic view that when US stocks rise Dollar will go up and when US stocks fall Dollar will fall. Most guests on CNBC TV also expressed the same simplistic view, but a few mentioned the yen-carry trades as the culprit. The simplistic view is flatly wrong as will be discussed in the following paragraph. Even the view of yen-carry trade is not correct in the exact sense, though we ourselves have committed similar sin in Comment 61 by casually talking about yen-carry trades. The case of yen-carry trades will be analyzed in detail after we deal with the simplistic view on major financial media first.

The logic behind the simplistic view is as follows. When US stocks fall, Japanese investors are scared and dump their holdings. Those Japanese investors will convert the dollars obtained from dumping of their stock holdings into Yen and run back to Japan. When US stocks rise, those Japanese investors will rush back into US market by selling their Yen for Dollar and thus creating the tight correlation between US stock prices and Yen-Dollar exchange rate. If this argument is true then it should also hold for European investors, and Euro should rise and fall against Dollar as US stocks rise and fall respectively. However, actual data show that when US stock prices fall and Dollar declines big against Yen, Euro always fall sharply against Dollar but not to rise as the simplistic view should have claimed. When US stocks rise and Dollar strengthens vs. Yen, then Euro becomes stronger against Dollar, again just opposite from the expectations of the simplistic view. This evidence alone should be already enough to dispel the simplistic view. Furthermore we can analyze the amount of Dollar in the hands of Japanese nationals to show the invalidity of the simplistic view. There are around 2 trillion dollars that have flowed into the hands of Japanese from the persistent trade surplus of Japan. About half of those dollars are in the hand of Japanese Government and are invested in short-term US treasuries. A large chunk of the remaining dollars had flown through the hands of large Japanese exporters but have been invested in the factories in US, China and around the world. Japanese life insurance companies and some Japanese individuals are also large dollar holders. This group are after higher yields in dollar denominated debt instruments since in Japan the yields are near zero since the middle of 1995. Most part of the remaining dollars are held by large Japanese trading houses and banks in the form of liquid assets. Japan is also not known as a hub for hedge funds. The actual Japanese money that jumps in and out of US stock markets cannot not be so large as to be able to cause giant swings in Yen-Dollar exchange rate. If the holders of the simplistic view are true to themselves, they must believe that the Japanese players in US stock market hold such a large sum of dollars as to be able to cause wild swings in Yen-Dollar exchange rates, and then they must conclude also that this huge sum of Japanese money is causing the wild gyrations in US stock markets too as it moves in and out of US markets. In that sense we should call the holders of the simplistic view the Japan-centric crowd besides Euro-centric and China-centric crowds.

Now let us turn our attention to yen-carry trades. In order to talk about the issues surrounding yen-carry trades, we need to investigate how yen-carry trades actually work. Let us pretend to be a hedge fund conducting yen-carry trades. Suppose the Yen-Dollar exchange rate is 100 Yen/Dollar, and we borrow from a multinational bank one billion dollar worth of Japanese Yen. We dump the Yen for Dollar and use this one billion dollars to buy US stocks. Now suppose Dollar drops to 95 Yen/Dollar. Irrespective of the movement of US stocks, we are already suffering 5% loss on the currency front since we have borrowed cheap Yen but now we need to repay with more expansive Yen. Thus yen-carry trades are very sensitive to the level of Yen-Dollar exchange rate. Any time when Dollar falls below the level where yen-carry trades were installed, those yen-carry trades will be unwound by selling US stocks, converting Dollar into Yen and repaying the Yen loan. The unwinding of a large amount of yen-carry trades will cause Dollar to drop further versus Yen as well as a sinking spell of US stocks. The major players of yen-carry trades are American and European hedge funds, not Japanese entities. Until very recently Dollar has been trading above the line of 105 Yen/Dollar most of the time since the middle of 1995. Majority of yen-carry trades were installed above this 105 Yen/Dollar line. When Dollar fell below 105 Yen/Dollar line in late September, the massive unwinding of yen-carry trades must have occurred and pushed both Dollar and US stocks sharply lower. By early October most of the existing yen-carry trades should have been unwound already. The wild gyrations of both US stocks and Yen-Dollar exchange rate since Oct. 7, that is our concern, cannot be due to the unwinding of plain vanilla yen-carry trades since not much of such ordinary yen-carry trades still existed by that time. We suspect that a new kind of strategy, called “synthesized unwinding of yen-carry trades” by us, is the source of havoc since Oct. 7. The strategy will be discussed below in detail.

The unwinding of a yen-carry trade can be abstracted into two steps, they are, the sell of US stocks and the buy of Yen. These two steps can be synthesized by selling stock index futures and buying Yen futures. The new strategy is to conduct those two trades almost simultaneously to simulate an unwinding of a yen-carry trade. There is no need to have a pre-installed yen-carry trade here. The next question is what are the advantages and disadvantages of such a trade. The aim of this kind of trade is to anticipate a falling stock market and profit from the short side of stock index futures. The buy of Yen futures is aimed to push Dollar sharply lower in order to panic Japanese entities that hold dollars and induce them to sell those dollars for Yen and thus to push Dollar down further. If the attempt is successful, this strategy will be a win-win trade. However, if the market goes against the trade, it will be a lose-lose disaster. Under the current unsettled financial market condition and as deleverage has become the order of the day, even most venturesome hedge funds will be hesitant to engage in such high risky gambling unless it is absolutely necessary. The natural candidate for this kind of strategy are the already distressed hedge funds. Quite a few hedge funds have jumped back to US stock market too early and have sustained heavy losses caught in the subsequent down draft of the market. Their unhappy investors are expected to withdraw substantial sums from those hedge funds at the next quarterly redemption date, November 15. The only way for those distressed hedge funds to raise enough cash to meet the expected onslaught of redemptions is to dump their stock holdings. They know very well that their large scale dumping will send the stock market sharply lower and will cause them more losses. Thus they will try the strategy of synthesized unwinding of yen-carry trades. Those distressed hedge funds will accumulate short positions of stock index futures prior to their destined date of dumping their stocks at every chance when stock prices jump temporarily. When their dumping of actual stocks starts, they will buy large number of Yen future contracts at the same time. This double punches will send both US stocks and Dollar fall like an avalanche. The awesome shock wave of the avalanche will panic substantial number of investors frozen in the stock market from fear and causes them to dump their holdings as well. The same argument applies to the dollars in the hands of various Japanese entities as well. The joining of those dumb money will turn the avalanche into a landslide. The short sell of stock index futures will protect instigating hedge funds until the end of their stock dumping by canceling out the losses from dumping of their stocks whereas during the down leg of the land slide, those short positions will actually generate net profits for the hedge funds. Same thing can be said for their long positions in Yen futures. By this win-win game the distressed hedge funds hope to net some profits to cancel out a part of their prior losses. The sharp down turn of both stocks and Dollar from the stretch of Oct. 20 to Oct. 27 probably was the result of such strategy of synthesized unwinding of yen-carry trades.

There are two factors that will stop the landslide triggered by synthesized unwinding of yen-carry trades. The first factor is the threat of intervention by Japanese Government. Japan is determined to preserve its remaining export industry so the sharply higher Yen vs. Dollar becomes a severe threat. However, Japanese Government has reasons to be hesitant in the currency market intervention. The first is the worry about international condemnation at the time G7 is repeatedly criticizing China for its currency market manipulation to prevent rapid appreciation of Chinese Yuan. However, Facing the relent less pounding on Dollar vs. Yen, G7 gave in and issued a joint communique expressing concern about rapid movements of Yen-Dollar exchange rate. This communique is a de facto approval of Japanese Government to intervene in the currency market in order to stop further fall of Dollar vs. Yen. Another hesitation of Japanese Government about the currency market intervention must be the cost of intervention. In the period from the fall of 2003 to the spring of 2004, Japanese Government bought up 400 billion dollars to prevent Dollar to fall through the line of 100 Yen/Dollar. As has been mentioned in Comment 61, Japanese Government needs to buy up 1 trillion dollars in order to keep the rising Yen checked at the level of 100 Yen/Dollar. That probably was the reason why Japanese Government did nothing when Dollar fell through 100 Yen/Dollar and only signaled its intention to intervene when Dollar fell close to 90 Yen/Dollar on Oct. 27. The second factor that stopped the land slide is the installation of new yen-carry trades. As discussed before, yen-carry trades need to be installed at lowest possible Dollar value vs. Yen. With Japanese Government signaling that 90 Yen/Dollar is its bottom line, the Yen-Dollar level close to 90 Yen/Dollar becomes the ideal point to install new yen-carry trades and a large wave of yen-carry trades probably did be installed. Sensing the turn of the tide, the distressed hedge funds that instigated the land slide using the strategy of synthesized unwinding of yen-carry trades certainly will not stand by idly to see their hard earned profits melting away. They will join the foray by closing out their short positions in stock index futures and selling out their Yen futures as fast as they can. Thus the joined forces of the installation of new yen-carry trades and the unwinding of those “synthesized unwinding of yen-carry trades” sent both the US stock market and Dollar to a rapid ascend as witnessed on Oct. 28. Three days after the giant surge of Oct. 28, on Oct. 31 when the writing of this comment is in progress, the momentum of that giant surge is still felt throughout the markets.

Looking ahead, we should note that yen-carry trades are quick to be installed and quick to be unwound. If those newly installed yen-carry trades decide to take profit and unwind, both US stocks and Dollar will suddenly tumble again. Also not sure is whether the needs of distressed hedge funds to dump their stock holdings has been exhausted. We better prepare to see such wild gyrations to continue for a while. We are not sure that the pattern of the wild gyrations in recent weeks is a bottoming out pattern. Before we can be certain we will consider the giant pattern on the chart just as a huge consolidation pattern. It means there are substantial chance the stock prices will break downward out of the consolidation pattern and start to search for a new bottom.