The yen's exchange rate is calling the tune for global markets, which are dependent on central-bank liquidity.
Forget the VIX. The new fear gauge for markets is JPY. A strengthening of the exchange rate of the yen -- mainly against the U.S. dollar but also against the euro -- has been a warning flag for global markets from stocks to bonds to commodities lately.
2-year chart
The yen had its biggest rise, and the greenback consequently suffered its biggest decline in terms of the Japanese currency, in three years Tuesday. The yen moved "three big figures'' -- to under 96 to the dollar from 99 -- a move that is virtually unheard of. (A lower number means a stronger Japanese currency because it takes fewer yen to buy a buck.) The plunge would be like a 450-point drop in the Dow Jones Industrial Average. But it wouldn't be a slash in the value of equities, the riskiest asset class, but in highly liquid money that is supposed to be a stable store of value.
Okay, the last point is a fiction promulgated in economics textbooks. In actuality, the express intent of the Japanese government has been to drive down the value of the yen. The aim was to reverse two decades of stagnation and deflation by making exports more competitive, also the textbook view derived from a 19th century mindset.
The reality is that cheap yen has been used to fund asset investment and speculation around the globe. Investors could borrow yen at virtually zero interest to invest in anything from U.S. stocks or junk bonds or emerging markets or even Japanese stocks. In effect, it was better than money for nothing; a speculator got paid to borrow in ever-depreciating yen.
Since it became apparent last November that Shinzo Abe would be elected Japan's prime minister on a platform of aggressive monetary and fiscal stimulus, global risk assets from emerging markets to U.S. stocks were in ascent. The Bank of Japan's money printing not only sent the Tokyo market soaring but also put the spurs to other risk-asset markets.
To emphasize, the BOJ's money printing had done more to boost asset prices by providing a source of cheap money than to stimulate the domestic economy. And the cheap yen was exploited around the globe.
The clearest example of the difference the yen made to non-Japanese investors is in U.S. exchange-traded funds. The WisdomTree Japan Hedged ETF (ticker:DXJ) was up more than 50% from its late 2012 levels at its peak in May. The iShares MSCI Japan Index ETF (EWJ), which doesn't hedge the yen, was up 30% at its peak last month.
Over that span, the yen went from under 80 to the dollar to over 100, a massive effective devaluation. But more recently, the yen has reversed course. Instead of marching toward further weakening to 120 to the dollar or more, it has slipped back into double digits. As a result, the best-laid plans of mice, men and the likes of hedge-fund managers are going awry.
That's become evident in the crash in prices that began in the wee hours Tuesday morning in North America when the BOJ disappointed markets around the world by announcing it would not expand its monetary injections as had been expected.
But that was only the latest hit to global markets, especially emerging-market equities, bonds and currencies, which have been crushed in the past few weeks. The lack of further easing by Japan's central bank has been exacerbated by uncertainty about possible curtailment of the Federal Reserve's $85 billion-a-month bond-buying program, which has gotten most of the ink.
It would seem markets have been roiled this week more by uncertainty over BOJ policies than the Fed's. The May employment report released last Friday -- which showed continued moderate payrolls growth and a minor uptick in the jobless rate due to rounding -- gave absolutely no reason to expect an early termination of the Fed's quantitative easing. And the U.S. stock market responded to the numbers with a 200-point spurt in the Dow Industrials Friday.
The rocky performance since -- including 1% drops in the major U.S. market averages Tuesday -- seems more related to uncertainty about Japan's monetary policy than that of the U.S. central bank.
The dollar, Treasuries and equities all were in retreat Tuesday morning, which was incongruous. A weaker greenback previously had benefited U.S. stocks; a lower dollar flatters the overseas earnings of multinationals. A triple-digit drop in the Dow, such as seen early Tuesday, once had reliably given a boost to risk-free Treasuries.
The simultaneous decline in all three markets suggested a withdrawal of liquidity, but not from the Fed, which would boost the dollar.
Treasury prices later rose and yields retreated from recent highs as videos of protests in Turkey were featured on news channels. But that was only one of the emerging markets that got hit Tuesday. The losers earlier included Thailand (down 5%), the Philippines (down 4.6%), Indonesia (down 3.5%.) Meanwhile, India's rupee fell to a record low against the dollar. All are symptomatic of a retreat from emerging markets. At the same time, Brazil and Poland had to act to support their currencies, which represents an implicit tightening.
The takeaway is the gains in risk assets around the globe have been generated mainly by central-bank liquidity produced in the U.S. and Japan (the European Central Bank actually has been shrinking its balance sheet at a double-digit annual pace.) The suggestion that the liquidity flow might be slowed -- "tapered" is the current buzzword -- has markets reeling.
Risk measures also have surged. The VIX jumped more than 10% Tuesday, to over 17, and is up more than a third from a month ago. Volatility gauges for bonds have increased even more, which forces trading accounts to reduce positions by formulas dictated by risk metrics.
It's looking like a long, hot summer for the bulls. Maybe it was right to sell in May, again.
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