US Markets: Technical Warnings and the Yen Carry

``Probability is omnipotent and omnipresent. It influences every coin at any time in any place, instantly. It cannot be shielded or altered. And probability is not limited to coins and dice and slot machines. Probability is the guiding force of everything in the universe, living or nonliving, near or far, big or small, now or anytime.” Scott Adams-creator of Dilbert, in God’s Debris

I have been saying all along that the recent rally in Wall Street has provided for a bullish backdrop in global equities, premised on a Goldilocks scenario.

Recently, considering the recent turn of events much like in the Philippine setting, the US markets looks technically overextended with an increasing likelihood for a sizeable correction in the near future. A correction in the US markets should extend to its global counterparts given their present high degree of correlation.

Quoting the normally bullish BCA Research on their invaluable insights (emphasis mine)...

Figure 4: BCA Research: Technical Warning for US Equities

``Momentum has started to negatively diverge from U.S. share prices, with the 13-week rate of change grinding lower despite new highs in the market. This diverging pattern was evident prior to the past four market consolidations or modest corrections since 2003. Another warning sign comes from our composite sentiment index, which has crested after reaching an optimistic extreme. A peak in sentiment from an extremely stretched level typically indicates that participants are fully invested and may be starting to retreat. Fundamental support for a setback in share prices includes declining earnings growth and reduced prospects for monetary stimulus. The recent back-up in Treasury yields has been sufficient to create a near-term headwind.’

In other words, BCA thinks that the prospects for a rate cut has been greatly reduced and the risks have now shifted possibly to a prospective tightening in the view of the higher Treasury yields.

In addition, as we mentioned before, in the light of a mid-cycle slowdown, the risks is tilted towards a deceleration of earnings growth rate which could somehow impact price-earnings multiples operating under the conditions of a “Goldilocks” rate-cut scenario. An implied prospective change of expectations from the present conditions could trigger such pullback.

Figure 5: stockcharts.com: Potential Jolt from Carry Trades

There are other possible sources of triggers that may induce a near term retracement, such as the unwinding of “carry trades”, and a possible rise of default incidences that could rattle the untested derivatives market and prompt for a cross asset market downside volatility contagion.

We should not forget that May 2006’s cross asset class sell-off has largely been in response to Japan’s administered increase of its bank reserves requirements which virtually prompted a spike in the Yen, the “funding currency” and consequently a selloff in the global markets, as shown in Figure 5.

The enclosed portion of the chart shows of how the spike in the Japanese Yen (red candlestick) coincided with the sudden selloffs in the US S & P 500 index (black line) as well as in the Phisix (lower panel).

Since a “carry trade” involves borrowing money from a low interest rate country, such as Japan’s Yen and using the proceeds to invest in higher yielding assets, where the profits obtained are derived from the spreads; a sudden tightening of the monetary policy or an abrupt jump in the value of the funding currency, which in this case is the Yen, could trigger a sellout in the invested assets which had been leveraged against the Yen for short covering.

Figure 6: S&P: Compelling Spreads

The compelling low-yield spread by Japan’s currency relative to the others has made the Yen carry a common feature in today’s global financial market’s arbitrage as shown in Figure 6. It is estimated according to some sources that about US$ 1 trillion could be at stake on the Yen carry.

In other words, a great deal of today’s liquidity driven markets could have been generated from the leverage arising from the carry trade arbitrage.

While the Yen today continues to drift along the four year lows against the US dollar, possibly providing fuel for the sustained run-up in global equities (see again figure 5), any precipitate departure from its downtrodden state could send tremors throughout the financial markets similar to that of May of 2006.

While there are those who argue that today’s highly sophisticated markets may have justifiably produced low volatility or reduced risk premiums or diffused risk concentration among the asset markets to allow for increased capacity to absorb greater leverage, it looks to me like risks have been simply remolded into different forms whose full blown impacts have yet to be seen and felt.