Insight: Forget the falling dollar but fear a rising yen

By Ken Fisher, chief executive of Fisher Investmentsand Fisher Wealth Management

Published: November 12 2007 17:42 | Last updated: November 12 2007 17:42

Forget the falling dollar. What we should fear is a rising yen. The most amazing statistic you never heard is: the year-to-date daily correlation between ups and downs in the global stock market versus spreads between the yen and the euro is 93 per cent. That is beyond eye-popping.

On days when the euro rises against the yen, stocks rise. On days when the yen rises to the euro, stocks fall. This year’s daily yen/euro changes perfectly track this summer’s stock market correction and subsequent resurrection. Make a chart of stocks, then the yen/euro spread; slip one on top of the other, and they are virtually indistinguishable.

It is driven by the yen carry trade financing the global bull market. But if anything torpedoes this bull market, it will be a rising yen, probably driven by Bank of Japan monetary tightening.

The same correlation is true, to a slightly lesser extent, for individual country stock markets and the relationship between the yen and other currencies.

The 2007 year-to-date daily correlation coefficient between changes in the yen/euro spread and the MSCI World Index – best reflecting the total developed world stock market – is 0.93. For the S&P 500, it is 0.89, for the FTSE 100, 0.86, and for Germany’s DAX, 0.87. All higher than most people can fathom.

The correlation of the MSCI World to the yen/sterling spread is lower, at 0.75, but is still sky-high. To the Australian dollar it is 0.86 and to the Canadian dollar 0.81. All breathtakingly high. Only to the U.S. dollar, which everyone fears, is it materially lower at 0.37.

What gives?

Today anyone with access to a global custodian can borrow short-term money in any major country. At Japan’s ultra-cheap interest rates, it makes sense to borrow there rather than where interest rates are higher.

People do, from all over the world, selling yen and moving the money to higher-yielding countries to invest, picking up the interest rate spread. To do so, they must also buy that new currency. The process pushes the yen down and other currencies up, and is called the yen carry trade.

That investors would do this to the extent they can is not surprising and is perfectly rational. Conventionally we think of it as people borrowing at low rates and lending into high-yielding countries like the UK to pick up the interest rate spread as free money. So if sterling does not fall materially relative to the yen, there is a free ride.

The process tends to be somewhat self-fulfilling, as people sell yen and buy high-yielding currencies like sterling, keeping the yen relatively weak.

The correlation between the yen/euro spread is high to major-nation bond prices too. What is shocking is that it is now higher still to stocks, and so very high. That started late in 2006 for the first time.

When we borrow short-term money in Japan, as elsewhere, that bank loan increases that country’s money supply, and in this case pours that money directly into capital markets all around the world, driving stocks higher.

The Bank of Japan is financing the global bull market directly without meaning to. The impact is immediate, and to the stock market, feels great. Most days when there is a big intra-day wiggle in the stock market, it is mirrored in the yen/euro spread too.

If you like rising stocks, you do not want to see a rising yen. If the Bank of Japan envisions Japan’s economy as adequately strong and suddenly changes policy, increasing interest rates materially – pushing the yen up – it would kill the carry trade.

That would scare those who have already taken carry trade money out of Japan, forcing them to reverse course, unwind their trades, sell stocks, and flood the money back into Japan. In the process, global stocks would suffer, as would the high-yielding countries’ currencies relative to the yen.

With the correlation this high, do not fear a weak dollar; fear a strong yen. Any material sign of Bank of Japan tightening would be very bearish.