They used to call a sudden rebound after a long fall a "dead cat" bounce. The theory was even a dead cat would bounce a little if dropped off a very high building. Cat lovers everywhere have complained since being acquainted with that saying with the advent of Internet trading. Since 9/11 that term has changed to a dead terrorist bounce since theoretically nobody would care and would probably click on You Tube to see them bounce again and again. Which label is correct? Rebound or bounce?
Nasdaq Chart - Weekly
SPX Chart - Daily
Friday was light on economics with only the International Trade report for April. The trade deficit rose slightly to -$58.5 billion from the prior month's -$62.4 billion. This 6.2% narrowing in the deficit came from an increase in exports and a reduction in imports. Crude oil and oil products represented $24.2 billion of that headline number and imports from China accounted for $19.4 billion. The drop in imports came from slowing autos and auto parts as well as consumer goods like flat screen TVs and capital goods. Since these figures are for April the deficit is likely to widen in May due mostly to the higher cost of oil over that period. This report is not a market mover although several analysts suggested the slowdown in consumer goods might have been due to slowing purchases by consumers hit by rising gas prices. I doubt this is the case. These numbers come from well up the supply chain at the distributor level and should not be affected by momentary pauses in consumer buying.
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While last week's calendar was very sparse in reported events the coming week will make up for it. Leading the list are the Producer Price Index (PPI) and Consumer Price Index (CPI). The Fed Beige Book report is on Tuesday and the first of the next round of manufacturing surveys, the NY Empire State Survey, is due out on Friday. The PPI/CPI are going to be the key reports. These will show us the inflation rates at each stage of the process and help predict the Fed's next move. If prices jumped significantly in these reports the expectations for a Fed rate hike sooner rather than later will also increase. Given the rate worries that shook the markets last week any further inflation shocks could be serious. Chicago Fed President Michael Moskow said in an interview on Friday that he expects strong GDP growth as the year progresses. He also said inflation is still a problem and will require additional Fed action to bring it down to a safe level.
There was little stock news on Friday with the majority of the focus still on interest rates. The yield on the ten-year note briefly touched 5.25% overnight and exactly the current Fed Funds rate. This is just over resistance from the spike high in June-2006 (5.245%) and touched levels not seen since 2002. To say this has been a major move since the middle of May would be an understatement. Bill Gross from Pimco, the largest bond firm in the U.S., turned bearish on bonds on Thursday after being a bond bull for 25 years. His statement on Thursday helped drive the equity markets to close at the lows for the day. He is now predicting yields as high as 6.5% over the next 3-5 years compared to his prior target of 5.5%. This may seem like a lot of fuss over nothing to equity traders but in the bond market yield changes are tracked in 100ths of a point. 6.5% would be a big move and to the already troubled housing market it could be a knockout punch. The housing market is facing a perfect storm in Q4 and Q1. The last series of adjustable loan resets will occur in those quarters and the interest rate could be dramatically higher. These loans were written in Q4-2005 and Q1-2006 when treasury rates were in the low 4% range. These loss leader loans will reset to something in the 7.5% to 8% range if the current trend continues and that could almost double house payments in some cases. Fed Funds Futures have fallen since April from a 100% chance of a rate cut by the end of 2006 to zero percent chance today. Chances of a rate hike in 2007 have risen from zero to 40% over the same period.
The equity market may have seen a steep bout of selling but the bond market has been under serious pressure since May 11th. Selling in bonds lowers prices and that pushes the yields higher. Overnight there was a surprise rate hike by New Zealand and that followed hikes by the ECB and SARB (South Africa) earlier in the week. With rates rising around the world analysts fear the global appetite for our debt will decrease. Several countries have already mentioned moving away from dollar denominated debt and that means our treasuries. On the bright side the yield curve has finally turned positive after months of inversion. This removes some fears of the bond market signaling a future recession. Actually the higher rates are indicative of rising expectations for stronger growth ahead. The ISM reports confirmed this last week with levels of activity at 12-month highs. On Friday Morgan Stanley boosted their estimates for Q2 GDP from their already high level of 3.6% to an unbelievable level of 4.1%. A rocket ride from the Q1 level of 0.65% to 4.1% in only one quarter would set off alarm bells at the Fed that would shatter eardrums. In his Thursday interview Bill Gross said he was now expecting global GDP to rise to 4.5%-5.0% over the next 2-3 years.
Another component hitting bonds came from convexity selling. Holders of home mortgage bonds were seeing rates rise and the value of those bonds decreasing. In order to hedge their multi billion dollar holdings and preserve their yield they are forced to sell treasuries. Two major bond analysts claim this was a contributing cause to the sharp downdraft in treasuries.
National Semi was a stock of note on Friday after beating earnings estimates on Thursday after the close. Earnings of 28 cents beat estimates of 23 cents. NSM also said its revenue slide should end this quarter and they were planning a $2 billion stock buyback program. NSM spiked +3.79 or +14.6% to $29.58 and it was instrumental in providing lift to the entire sector. Next week TXN will provide its mid quarter update and that will keep the buzz alive. Also helping produce a tech rebound was expectations for the Bear Stearns Technology Conference and the World Wide Developer Conference (WWDC) also happening next week. Steve Jobs will be the keynote speaker at the WWDC.
AMD was the recipient of an unknown rumor that caused an extreme number of calls to be traded. I say unknown because nobody could find a cause for the surge in volume. On Thursday more than 245,000 calls were traded around the $14 and $15 strikes with the stock trading just under $14. On Friday 35,000 calls traded in just the expiring June strikes compared to about 3500 puts. Quite a few traders are betting on news event very soon.
Other extreme option volume came in the Amazon and Netflix options. Amazon is rumored to be ready to make a play for Netflix making NFLX calls a hot commodity along with puts on Amazon. Average daily call volume on NFLX is 1,172 and put volume on AMZN is 6,080. On Wednesday NFLX saw 58,947 calls traded followed by 70,991 on Thursday. Amazon puts traded 31,251 on Wednesday and 59,855 on Thursday. The Amazon-Netflix rumor has been around before. Actually around and around and around about every six months for years. This is the first time that the option volume has been this extreme. What gives the rumor more credibility this time is the Amazon stock price. It has more than doubled in the last 12 months and they have seen a 75% gain in their market cap just since April-1st. It has not been this high since March of 2000. This gives Amazon a blank check opportunity to spend some of that expensive stock on an acquisition that would give them 6.8 million paying subscribers and produce a strong boost to Amazon's downloadable video service. Unfortunately Netflix is embroiled in a fight to the death with Blockbuster and appears to be losing. Blockbuster added +800,000 customers to its Total Access service in Q1 while Netflix only added 481,000. Blockbuster allows customers to swap out movies at local stores without waiting for the mail. It may be the right time for Netflix to agree to a takeout to gain market breadth.
Option volume in general is exploding. The NYSE reported a 4% increase in stock trading volume from April to May. The CBOE reported a 40% increase in option volume for the same period. The average daily contract volume in May 2006 was 3.4 million contracts. In May of 2007 that volume rose to 10.8 million contracts. Analysts are blaming "rumortrage" for the increase. With the current merger and acquisition binge setting records, hundreds of stocks are targeted with rumors each month. Option volumes spike for a couple days and then fade when nothing happens. On the rare occasion that a stock is taken out the option players are well rewarded. Unfortunately the number of winners is far less than the number of losers.
Russell-2000 Chart - Weekly
Option volume is only going to increase as we near the annual rebalance of the Russell indexes on June 22nd. To be eligible for inclusion in the Russell indexes a company must have a market cap in excess of $233 million (Russell-2000) and trade on a major exchange for more than $1. Each year Russell ranks all the stocks in its universe and then names the top 4000 to its indexes. The top 1000 are considered big caps and are included in the Russell-1000 index. The middle 2,000 are considered small caps and are represented in the Russell-2000 index. The bottom 2000 are considered the Microcap Index. More than $3.8 trillion in global fund dollars are reportedly indexed to the Russell indexes. On Monday June 11th Russell will announce its additions and deletions to the indexes. Those changes plus the re-weighting of stocks originally in the indexes will take effect at the close on Friday June 22nd. The key here is the attention focused on the new entries and their impact to the overall index. If little known company XYZ is named to the Russell-2000 there are hundreds of fund managers that must buy it in order to match the index. If a new big cap company like MasterCard (MA) has IPOed over the prior quarter then they will take their place in the index and every other stock with a smaller market cap will shift down one notch. That means every fund manager will have to buy the large company and sell some shares in every company below them. There were 35 IPOs in Q1, which have been added to the indexes and will impact the new weighting of the overall index. Of course there are some smaller companies that have grown from the prior year and they will rise in the indexes pushing others even lower. It is a massive rebalancing and guaranteed to give fund managers a serious case of indigestion. The best way to play is to buy the companies being added to the indexes and sell the ones being expelled. This list will be available from Russell on Monday. The chart below shows how the indexes are structured according to market capitalization. The Russell-2000 iShares (IWM) are used by many as a market proxy. They buy calls when they are bullish and hedge their portfolios with puts when they are bearish. On Friday 178,747 calls were traded and 689,524 puts. By far the largest activity was in July puts with more than 240,000 traded. That should give us some idea about where market sentiment lies this weekend.
Russell Index Chart
Rumors about the death of the M&A binge have been drastically overstated. With the rise in rates some are claiming the current M&A boom will die. That did not stop speculation in U.S. Steel on Friday when rumors caused a +7.9% spike at 1:PM. The potential suitor was rumored to be Germany's ThyssenKrup. US Steel has a market cap of $14.7 billion. Analysts say the merger would be an "incredible combination" according to KeyBanc Capital Markets. However, ThyssenKrup, is in the middle of a $7 billion expansion plan to build three new billion dollar mills. It may not be the right time but those speculating in US Steel on Friday were not concerned.
Gold was hammered for the week falling more than $20 to 671.50. A noted gold bull, Frank Barbera, sent a flash update to his readers this week warning them that the tide had turned. He claims gold tried three times to break through the resistance high at $700 and failed setting up a technically bearish scenario. Stronger growth estimates also dampened gold buying as an inflation hedge. He said prices could slip as far as $510. For whatever reason gold prices suffered a serious rout and the StreetTracks Gold Shares (GLD) was forced to liquidate nearly 40 tons of gold from its inventory from late April to the end of May. Dang, 40 tons is enough to crush prices without any other outside event. When gold bugs run to hide they go in swarms. Analyst Richard Suttmeier was less bearish and is looking for a drop to $639 as an entry point into a new long position.
Traders were so intent on buying the dip on Friday that they completely ignored a serious problem at Qualcomm (QCOM). The U.S. International Trade Commission banned importation of any future cell phone models made with Qualcomm chips. The ITC issued the ruling in a patent dispute between Qualcomm and Broadcom. Since the industry debuts new models almost weekly this will be a severe blow for the companies selling phones with Qualcomm chips. The ban impacts the high-speed EV-DO and WCDMA network technologies. Carriers who rely on that technology and to be hurt the most are Verizon and Sprint. Phone makers likely to be hurt are LG Electronics, Samsung and Motorola. Motorola was scheduled to release its new RAZR 2 later this year with Qualcomm high-speed technology. Qualcomm is going to ask the Federal appeals court to block the order for 60 days to give them time to appeal the ruling. They are also going to ask President Bush to overturn the decision. Presidents have overturned ITC decisions only five times in the past with the most recent event in 1987. The White House said it would defer the decision to the U.S. Trade Representative as it has since Bush started his second term. Qualcomm said it could take up to two years to develop a new chip that does not infringe on Broadcom patents. Qualcomm's competitor Nokia would be unaffected by the decision. Broadcom said it remained open to discussing the rights to its patent but Qualcomm said Broadcom's demands were unacceptable. If the USTR refuses to overturn the ban Qualcomm will find those terms suddenly acceptable rather than go two years without selling any phones in the states. The carriers and manufacturers will be leaning on Qualcomm very heavily to settle if the ruling stands. QCOM rose +85 cents and BRCM gained 46 cents. It appears nobody was watching the news OR they could not believe the verdict would stand.
After hitting $67.42 on Thursday the price of oil fell off a cliff on Friday losing -2.17 or -3% to close at $64.79. The spike had come on worries about possible damage from Typhoon Gonu and news that Turkish troops massing on Iraq's border had crossed into Iraq. According to Turkish officials the troops crossed the border in hot pursuit of some Kurdish rebels operating out of Iraq. There were worries that Turkey could launch an offensive against the rebel bases in Iraq and cause problems for U.S. backed Iraqi Kurds in one of Iraq's most stable regions. There were concerns they may try to occupy some of the northern oil fields but that rumor was quickly crushed by officials on both sides. The Typhoon has dissipated into a rainstorm as it moved farther north and there was no damage reported to any oil installation. I continue to expect oil prices to remain in a range between $63-$68 while we wait on the hurricanes. Gas prices have eased about six cents nationwide and about 28 cents on the futures side. However, gasoline demand continues to be strong and was 128,000 barrels per day above the same week in 2006. The last four weeks has seen demand much stronger than 2006 even with the higher prices. Retail gasoline averaged $2.86 per gallon for the same week in 2006.
Gas Demand Table
Overall it was an ugly week. The rainstorm I profiled on Tuesday turned into a category 3 squall as the week progressed. The Dow dropped -439 points from the 13690 high set on Monday to the 13251 low on Friday. The drop beginning on Wednesday was nearly vertical and on strong volume. Thursday's volume soared to an astounding 6.74 billion shares with down volume more than 10:1 over up volume. Up volume was 575 million shares while down volume was 6.125 billion shares. Advances were outnumbered 6:1 by decliners. On Friday the internals were reversed with up volume of 4.67 billion shares to down volume of only 795 million. The table below highlights the volume shifts and the change in new highs/lows. Note new highs dropped from 856 on June-1st to only 77 on Friday while new lows rose.
When I began this commentary on Friday evening I had a slightly bearish bias. However, after looking at the internals and at dozens of stocks that rocketed off their lows I am about ready to return to a bullish stance. The Dow declined below several levels of support including the uptrend from November and the 30-day average, which had been short-term support prior to the February crash and was about to reassert itself again. That average was about 13400 on Wednesday and it was broken by -150 points or so. Friday's rebound back above it was reassuring but not enough so that I am ready to call it a rally and not a dead terrorist bounce.
Dow Chart - Weekly
Dow Transport Chart - Weekly
There are so many people claiming we are going down hard again next week that I think we should consider that a contrarian signal. Some are targeting 13000 or even 12500 and I just don't see it. I have been wrong before but the capitulation like volume on Thursday and the lopsided internals on Friday have all the earmarks of a valid rebound. Quite a few analysts, myself included, had remarked in print that the retail investor and quite a few fund managers had not thrown themselves behind the April/May rally. The sell in May and go away crowd had convinced them that waiting for a better entry later in the summer was a better plan. I believe that entry came last week. It could have been worse but frustrated investors of every type rushed in from the sidelines and overcame sellers on Friday. The major correction everyone had been predicting failed to appear and now all the bears are short again along with their friends. With dozens of on-air personalities proclaiming another leg down for next week it suggests the shorts loaded up on the drop and they are going to be scrambling next week if buyers continue to appear.
I believe a lot of Friday's afternoon bounce was short covering as some traders took profits from the drop but it was not as hectic as you would have expected from the vantage point of Thursday's close. That suggests to me that quite a few are short over the weekend. That is a brave position to take ahead of merger Monday. Friday's rebound was the 12th consecutive Friday the Dow has closed with a gain. That tells me a lot of traders want to be long in front of merger Monday and not short. The difference in opinion is what makes a volatile market.
You may remember on Tuesday I wrote that I expected a big move later in the week to coincide with options expiration. I believe funds rolling positions ahead of next week's expiration were a factor in the drop but not the only factor. The excuse was the bond yields over 5% but I believe that was just an excuse. Yields could be 4.8%, 4.9% or 5.1% and there is no material difference. I know it is psychological once it goes over 5% but I just don't see the real life connection to cause a sudden -439 point drop. From the way the selling progressed I believe we could have seen several funds using the 5% trigger as an excuse to take profits. Their selling along with Bill Gross announcing his conversion to a bear triggered a few more to join the party and the rest is history. Any major 200-300 point drop will trigger stop losses and margin selling. It is not a conscious effort to sell but pre programmed decisions designed to protect capital. We had a downdraft, stops were hit and Bill Gross flushed a fledging rebound attempt at 3:15 on Thursday. Traders had already started buying the dip and those comments caught them leaning the wrong way. Stops were hit, new longs were dumped and a small wave of panic hit the market. By the time his comments were repeated in context on the airwaves the market had already closed. Everybody crowded any available microphone predicting a disaster at Friday's open. Twice sellers tried to take it down, once at the open and again at 10:45 and neither try was backed with any conviction. Once the rebound began at 12:45 it was a decent pattern of short, cover and repeat for the rest of the day. Bears refused to believe the rebound would stick and bulls refused to believe it would fail.
Given the big move last week we are not likely to see any option expiration gyrations next week. Anybody that had profits closed their positions and those positions with no hope now have even less. What will move the markets next week are the PPI and CPI and possibly the Beige Book. Inflation concerns are rising along with the GDP estimates. While nobody actually expects the Fed will hike again in 2007 due to the impact to the housing sector the possibility will be cussed and discussed ad nauseum for weeks to come. It is not relative to the short-term direction in the market but the media will try and make it relative.
We are only about four weeks from the start of Q2 earnings and two weeks from
another two-day Fed meeting. We could have some additional volatility around the
Fed meeting but most will assume the Fed is on permanent hold and see a bullish
future for stocks. I am not going to pick a direction today but I do have a
slightly bullish bias heading into next week. Monday will be the key. If the
rebound continues and can push past Dow 13500 the doomsayers will crawl back
under their rocks
and money will pour back into the market. A failure at 13500
or below will reinforce the correction theorists and the bears will load up on
shorts once again. Make no mistake about what happened last week. Market
sentiment was damaged and that put the buyers on the defensive. Nothing will
change that posture faster than a strong day of bullish follow through on
Monday. Let's hope the buyers are tired of waiting on the sidelines and dive in
with reckless abandon. Until then I would cautiously
buy the dip above Dow
13250. A break there would seriously damage bullish sentiment even further.
Play Editor's Note: We are extremely leery of the market at this point. Yes, the trend is still up. However, the Wednesday-Thursday sell-off last week did a lot of technical damage. We are reluctantly bullish. Most of the candidates we found this weekend were for bullish positions. Yet we strongly suggest that readers hesitate to open new bullish plays and if you have bullish positions open you may want to double check your stop losses and keep your finger near the sell button.
Ashland - ASH - cls: 61.49 change: +0.94 stop: 59.95
Why We Like It:
BUY CALL JUL 60.00 ASH-GL open interest=301 current ask $2.90
Picked on June 10 at $ 61.49
Avery Dennison - AVY - cls: 65.64 chg: +1.13 stop: 64.19
Why We Like It:
BUY CALL JUL 65.00 AVY-GM open interest=1103 current ask $2.30
Picked on June xx at $ xx.xx <-- see TRIGGER
FTSE/Xinhau China Index - FXI - cls: 115.70 chg: +2.86 stop: 111.90
Why We Like It:
BUY CALL JUL 115 FJJ-GK open interest=769 current ask $5.30
Picked on June xx at $ xx.xx <-- see TRIGGER
General Dynamics - GD - cls: 80.58 change: +0.96 stop: 78.35
Why We Like It:
BUY CALL JUL 80.00 GD-GP open interest=626 current ask $2.50
Picked on June 10 at $ 80.58
China Life - LFC - cls: 47.66 chg: +1.44 stop: 45.75
Why We Like It:
BUY CALL JUL 45.00 LFC-GI open interest=4922 current ask $3.80
Picked on June xx at $ xx.xx <-- see TRIGGER
QUALCOMM - QCOM - cls: 41.87 change: +0.85 stop: 44.05
Why We Like It:
BUY PUT JUL 45.00 AAO-RI open interest=50440 current ask $3.20
Picked on June 10 at $ 41.87
Baker Hughes - BHI - cls: 83.02 change: +0.19 stop: 79.95
Oil stocks participated in the market-wide bounce on Friday even though crude oil futures plunged over 3%. Traders bought the dip in BHI at $81.81. We were expecting a steeper decline into the $81-80 range. While we are encouraged by the bounce we're concerned that's all it is - a bounce. The bullish breakout over resistance near $84.00 last week has reversed. The P&F chart probably says it best by calling it a "bull trap". We remain fundamentally bullish on the oil stocks but we're wary of new bullish positions in BHI under $84.00. More aggressive traders may want to consider buying a bounce from here. We are suggesting readers wait for a new rise past $84.00. Furthermore we are suggesting that readers consider a tighter stop loss. Currently our target for BHI is the $89.00-90.00 range.
Picked on June 04 at $ 84.26
Global SantaFe - GSF - cls: 67.93 chg: -0.61 stop: 65.90
While most of the market bounced on Friday shares of GSF continued to sink. The stock lost 0.88% but did manage to rebound from its lows around $66.65. At this point we would wait for signs of strength in GSF before considering new positions. A rally past $69.00 or maybe a new high over $70.80 might be used as new entry points for bullish positions. More conservative traders could place their stops under Friday's low.
Picked on June 03 at $ 68.86
Vangard Emergy Mkts ETF -VWO- cls: 87.54 chg: +2.01 stop: 84.99
Friday's bounce in the VWO was impressive. The ETF rose 2.3% and closed near its highs for the session, which should be bullish for next week. If you think the VWO can breakout past the $90 level then this looks like a new entry point for bullish positions. We're not suggesting new plays at this time. Our target is the $89.85-90.00 range.
Picked on May 16 at $ 86.15
XTO Energy - XTO - cls: 60.52 chg: +1.02 stop: 56.74
XTO continues to show relative strength. The stock rose 1.7% and did so on big volume. After the closing bell on Friday Jim Cramer, host of Mad Money on CNBC, gave a long and enthusiastic endorsement of XTO as one of his favorite oil stocks to own, especially after the recent asset acquisition from Dominion. We wouldn't be surprised to see XTO shoot higher on Monday. Please note that we are adjusting our target from $62.50-65.00 to $64.75-67.50. More conservative traders may want to tighten their stops toward $58.00.
Picked on May 27 at $ 57.63
Anixter Intl. - AXE - cls: 69.06 chg: +0.36 stop: 71.55
The last few weeks has seen AXE create a bearish double-top pattern under resistance near $75.00. The recent sell-off broke support at the $70.00 mark and its rising 50-dma. AXE produced an oversold bounce on Friday but the rebound struggled under the $70 level. This looks like another entry point to buy puts. We are aiming for the $65.25-65.00 range. The P&F chart is bearish with a $63.00 target.
BUY PUT JUL 70.00 AXE-SN open interest= 44 current ask $2.95
Picked on June 07 at $ 68.99
Gilead Sciences - GILD - cls: 79.00 chg: +0.42 stop: 82.55
GILD also participated in the market's widespread bounce on Friday. Yet the rebound couldn't make it past round-number resistance at $80.00. We would use this bounce as a new entry point to buy puts. If the stock continues to bounce then look for resistance at $80 and again at $81.00. A failed rally under either level could be used as a new entry point. Our target is the $75.25-72.50 range. FYI: The stock is set to split 2-for-1 on June 25th. The P&F chart shows a new quadruple bottom breakdown sell signal with a $71 target.
BUY PUT AUG 80.00 GDQ-SP open interest=4904 current ask $3.50
Picked on June 07 at $ 79.90
Vital Images - VTAL - cls: 26.20 chg: +0.18 stop: 29.05
VTAL hit another new relative low on Friday (25.73) before bouncing back. The rebound was pretty anemic and we remain bearish although we're not suggesting new positions. If the markets continue to bounce then we could see VTAL make a rally attempt toward the $28 level. More conservative traders may want to tighten their stops a bit. Our target is the $25.15-25.00 range.
Picked on May 16 at $ 27.99
"So, what do you think about China?" someone asked me the other day when he learned that I wrote for an options-trading website. This was a day or so after China's bourse lost more than six percent in a single night in late May, but before our own markets fell ill this week from the latest version of the Asian contagion.
I was more concerned about the relationship of the dollar to the Japanese yen. Here's why, as demonstrated on a chart snapped Saturday, June 2, when I first began roughing out this article.
Annotated Weekly Chart of the USD/JPY:
I had begun paying special attention to the yen after February's sharp decline, when so many market commentators, including one on our site, insisted that the health of the globe's bourses depended on the continued health of the yen carry trade.
Investopedia.com explains a currency carry trade in terms simple enough for anyone to understand. The site explains that traders might borrow yen because the interest rate in Japan is so low. Then, traders might change those yen into dollars and use the dollars to buy other investments, often U.S. or German bonds but also stocks from various countries. Because U.S. bonds pay a higher interest rate, traders benefit by receiving a greater interest rate than they're paying for the borrowed yen. If they're buying stocks that are rallying, their gains are greater than the interest rate they're paying.
However, Investopedia warns that the yen carry trade can go wrong rather quickly if the yen were to rise against the dollar, in the example provided. Often those traders who are engaging in the carry trade are highly leveraged, so their losses mount quickly. Others would warn that the yen carry trade could as quickly go wrong if stocks dove.
Therefore, if the yen carry trade is important to the health of the globe's bourses, it seemed plausible that the correlations in the USD/JPY chart and charts of rallying U.S. equities might have a cause/effect relationship. A March 5, 2007 article in TheStreet.com asks whether it was the February implosion in the Shanghai Composite that caused an unwinding of the yen carry trade, subsequently impacting other global bourses, or whether it was the rise of the yen against the dollar and Euro that caused that implosion. Different economists, all more learned than I am in economics, hold different opinions as to which happened first, as they might with the latest implosion, too. However, all economists quoted agreed that a linkage in equity weakness and currency changes does exist.
As the week of May 28 ended, the USD/JPY appeared to be approaching an important flexion point, leading to my speculation that perhaps U.S. equities were, too. The USD/JPY was again approaching the year's high, a high reached just before the February slide in both the USD/JPY and U.S. equities. Moreover, the chart displayed tentative bearish price/RSI divergence. The daily chart isn't shown here, but those divergences were apparent on that chart. They looked much as they had in late January and early February, before the USD/JPY slid lower.
Friday, June 1, the USD/JPY had approached within a few cents of the year's high before retreating slightly. The week's candle could have been interpreted as a bearish one. That potential bearish price/RSI divergence existed. A check of news that Friday and Saturday revealed that market watchers were growing increasingly concerned that the Bank of Japan might raise interest rates sooner rather than later, with yields on the ten-year government bond reaching a seven-month high and, on the two-year, a decade high. Although details weren't readily available, the government had also drafted a new income tax policy. Rising interest rates also escalated fears that the yen would rise against other currencies.
News items appeared to support the idea that the carry trade could be adversely impacted, something that might be detectable if the USD/JPY pair pulled back from the resistance it was facing, as it was ultimately to do this week. However, that action was far from a certain thing at that vantage point on June 1 and 2. Resistance was there, but resistance had seemingly meant little on any entity, on any chart, over the previous months.
The stage appeared to be set for a big move one direction or the other, but which direction would it be, it was possible to ask that Friday and Saturday. Would we be able to watch the movement of the USD/JPY and either predict or corroborate what we were seeing on equities?
I was going to be watching, but I wasn't sure it would be so easy. Inter-market relationships are complex, with yields or interest rates, currencies, equities and commodities interacting in a complex fashion, so that one inter-market relationship might function one way at one time and another at a different time. For example, at the same time that the USD/JPY was approaching that resistance level that Friday, June 1, U.S. ten-year bond yields broke above their previous year's high. The next chart was also snapped as this article was first roughed out, on Saturday, June 2.
Annotated Daily Chart of Ten-Year Yields:
The lesson seemed to be that inter-market relationships can be complex. A relationship, inverse or otherwise, can appear to be solid but can transform.
Or transform again. By now, we all know what happened this week. Bond yields broke higher this week, with ten-year yields spiking above the psychologically important 5.0 percent level (50.0 on the chart). That hurt equities.
In addition, the yen rose against both the dollar and the euro, so that the USD/JPY chart revealed a sharp pullback that was mirrored in U.S. equities.
Annotated Weekly Chart of the USD/JPY:
It's clear that next week may present another flexion point for these currency pairs and maybe for equities, too.
The lesson? There are two lessons. Those of accustomed to trading on technical indicators, believing that all market knowledge is reflected in the chart of the security we're watching, still must pay attention to inter-market relationships. They provide us with important clues, sometimes giving us a heads-up to what might be about to occur or sometimes corroborating what we're seeing. I don't know whether the swoon in equities in February and again last week prompted a partial unwinding of the yen carry trade or whether the possible unwinding of the yen carry trade caused those swoons. Several economists expert in their fields can't seem to agree, and neither can they agree as to the ultimate outcome. A RealMoney.com commentator was quoted in TheStreet.com's article as saying that a full unwinding of the yen carry trade wasn't likely to happen, given the fact that Japan's interest rates were still so low compared to that in the rest of the world.
The second lesson is that the relationships don't always hold true. The inverse
relationship of yields to equities that held for a while was unbuckled for part
of this year, but may have reasserted itself once yields reached a
psychologically important level. Watch these inter-market relationships, then,
but then let the price of the entity you're watching be your final arbiter after
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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