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What's Controlling Our Markets?

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"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 all.

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