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The Yen, the Dollar and the Dow   (October 15, 2007)

Many commentators have noted that the yen carry trade (trading firms borrowing in yen at 1% and investing in higher yielding U.S. stocks and bonds) seems to support the U.S. markets. Other analysts have noted that the U.S. market seems to rise when the yen weakens (above 115) and declines when the yen strengthens (is below 115 to the dollar).

Note that when a dollar buys fewer yen (say, 100 yen) the yen has strengthened, while if a dollar buys more yen (say 120 yen) then the yen has weakened relative to the dollar. The Japanese Central Bank famously intervenes to weaken the yen whenever it strengthens too much (apparently the line in the sand is 110 or so) to keep Japanese goods competitively priced to U.S. consumers and to keep Japanese export-corporate profits high.

If a Japanese company only receives 85 yen for a $1 sale in the U.S., then they certainly are earning a lot less of their money than if they receive 120 yen for that same $1 sale. Yen at 85 = strong yen, yen at 120 = weak yen.

So let's look at some charts, courtesy of frequent contributor Harun I. I have formatted them to this site, reducing the detail but enabling us to identify trends.

What can we discern in the three charts?

1. As the dollar weakened March - June, the yen strengthened--just as you'd expect as the dollar dropped.

2. But on June 18, the yen reversed, and weakened even as the dollar continued dropping. In fact, the yen weakened more than the dollar--as if something or someone was desperate not to let the yen rise in value relative to the dollar even as the buck dropped.

3. As the U.S. stock market plummeted to its Aug. 16-17 low, the yen weakened to an extreme and the dollar actually popped up.

4. Since the mid-August stock market low, and the Federal Reserve's half-point drop in the interest rate mid-September, the dollar has plummeted. Yet even as the dollar fell off a cliff, the yen continued to weaken, too. How is that possible? I can only think of one answer: massive manipulation/intervention which sank the yen, countering what should have been a yen-strengthening trend as the dollar weakened.

5. As the dollar dropped, the U.S. stock market soared.

6. Around October 1, the yen finally succumbed to the declining dollar and reversed course, turning from a weakening trend to a strengthening trend. To date, this change has had no discernable effect on the U.S. stock market or the dollar, which halted its precipitous decline for a brief period of time.

7. Does this yen reversal portend a change in the dollar or the U.S. stock market? As the dollar has dropped, the yen should have continued to strengthen. Instead, it rapidly weakened from mid-June to October 1. Isn't that a bit odd?

The weak yen makes for a profitable carry trade. Here's why: if you borrow in yen at 120/dollar and buy U.S. stocks and bonds, and then sell and take your profits, you have to sell your dollars and buy back the yen to pay back your loan. If you borrowed yen at at 120/dollar and bought the yen back at 100/dollar, what happened? You lost 20% of your money in the currency exchange. A stronger yen is a catastrophe for the carry trade.

Since currency trading is often highly leveraged, this swapping of dollars for yen and vice versa is especially fraught with risk.

So what can we conclude? I am only a pawn in the big game of life, but it sure looks like someone intervened on a massive scale to weaken the yen since mid-June, when the U.S. stock market began to falter. This became more and more difficult to sustain as the dollar slid down a steep slope, and the U.S. stock market reflected this increased risk in the carry trade by becoming volatile.

Since October 1, the U.S. stock market has continued rising even as the yen strengthened and the dollar clung to record lows. As the yen strengthens, the carry trade becomes more precarious and its ability to support the U.S. stock market recedes.

To date, this strengthening trend in the yen has had no visible effect on the U.S. market. But how long can it continue before it does have a negative effect? If the dollar resumes its slide, and the yen continues strengthening, the carry trade support of the U.S. market vanishes.

Will that be enough to cause the U.S. market to reverse into a steep decline? Maybe not, but it certainly would knock a key prop out from under it.

Thank you, Kent M., ($25.00) for your much-appreciated generous donation to this humble site. I am greatly honored by your contribution and readership. All contributors are listed below in acknowledgement of my gratitude.

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copyright © 2007 Charles Hugh Smith. All rights reserved in all media.

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