The end of the ‘carry trade’? How Japan’s yen could be ripping through U.S. stocks

The key driver of global markets is the yen exchange rate, according to one financial historian, who warned the trend should concern those “entirely focused on U.S. domestic dynamics in trying to assess price outcomes.”

Russell Napier, co-founder of the investment research portal ERIC, said in a recent installment of his “Solid Ground” macro strategy report that investors have been provided with a glimpse of the impact that a change in Japanese monetary policy can have on U.S. financial markets.

“That there is such a strong relationship between the structure of monetary policy in China and Japan and US assets prices will come as a huge shock for most US investors,” Napier said in a report published Tuesday.

“The narrative for the past few decades is that the US is, in economic and financial terms, an island largely un-impacted by such global trends.”

Stocks are experiencing a broad slump, with many market participants caught off guard by the speed of the yen’s rally.

The Japanese currency is up around 8% against the U.S. dollar over the last month, trading at 148.84 a dollar on Friday. It marks a stark contrast from the run-up to the July 4th U.S. holiday, when the yen fell to 161.96 per dollar for the first time since December 1986.

The rising yen has fueled speculation about whether this could mark the end of the popular so-called “carry trade” — wherein an investor borrows in a currency with low interest rates, such as the yen, and reinvests the proceeds in a currency with a higher rate of return.

“The now evident vulnerability of US equity prices to a rise in the Yen exchange rate warns of the consequences for US asset prices and developed-world asset prices in general from monetary policy changes in the east,” Napier said in the Tuesday report.

He cited the recent rally in the Japanese currency as an example where selling pressure from investors seeking to repay their yen debt had pushed prices of U.S. equities down, while yields on U.S. government debt continued to decline.

“That the US equity market should react so negatively to this rally in the Yen is the shape of things to come, and an indicator to investors of how inter-related US equity valuations are with the global monetary system,” Napier said.

U.S. stocks kicked off the month sharply lower, as fresh data prompted fears of a worsening economic outlook. The weak data led investors to worry that the Federal Reserve may be behind the curve in cutting interest rates to fend off a recession.

The Dow Jones Industrial Average on Thursday fell nearly 500 points, or 1.2%, while the S&P 500 shed 1.4% and the Nasdaq Composite slipped 2.3%.

Cedric Chehab, global head of country risk at research firm BMI, said Friday that a combination of factors have been at play over the past roughly 10 day-period. However, he insisted “corrections like this are absolutely normal” at this time of year.

“First of all, the hawkish Bank of Japan caused an implosion of the carry trade over a short-term basis. We also had bad manufacturing data out of the U.S. and some employment sub-indicators which scared markets,” Chehab told CNBC’s “Street Signs Asia” on Friday.

“And then overnight, we saw a lot of volatility in some of the major earnings. And all of that helps push equity markets, which had been quite expensive, even lower,” he continued.

Chehab said one factor that some investors appeared to be forgetting was that there is typically a seasonal rise in equity market volatility over the July-October period.

Separately, Napier said that a recent downturn in U.S. equities was likely to have significant ramifications for yen carry-trade investors.

“This negative reaction of US equity prices will be exacerbated in a financial repression as the carry trade investors will be forced to sell at the same time as Japan’s financial institutions are forced to sell to purchase [Japanese government bonds] as directed by the Japanese authorities,” Napier said.

“With the Yen so undervalued and the need for financial repression in Japan now imminent, investors should not expect US equity valuations to continue to rise when this change comes.”

Napier concluded that the moves in the yen exchange rate in recent weeks and the impact on U.S. equity prices “provides some early warning indicator of the scale of the difficulty for the US in sustaining the unsustainable when foreign investors enter a period of capital repatriation to a home bias which will likely last over a decade.”