If you have been following the classic carry trade of late you may have noticed the best “risk on” vs. “risk off” indicators available to traders and investors. If not this may help. The Australian Dollar vs. the Japanese Yen has been one of the primary carry trades of the past five to 10 years.
As you probably know, the carry trade involves selling a low yielding currency to finance the purchase of higher yielding currency to make money on interest rate spread. Textbook risks = changes in interest rates and/or central bank interventions.
Right now the Australian 10-year bond yields ~3.35% and the Japanese 10-year yields ~0.74%
Some context
The Japanese just elected a new Prime Minister, Shinzo Abe of the Liberal Democratic Party. Abe held the same position between 2006 and 2007, but left for health reasons . There have been five others to hold the office since Abe departed with the longest tenured being Yoshihiko Noda of the Democratic Party, who held the position for 481 days. Is Japanese job security a thing of the past?
Abe has vowed publicly to force the Bank of Japan to replace it’s slack 1% target for inflation with a binding 2% target and is willing to undertake “unlimited easing” to achieve the goal. To this point, Shinzo makes Charles (The fire-hose) Evans look like an inflation hawk.
Going back to the AUD/JPY indicator, it is interesting to see how risk markets performed in the months following the Aussie/Yen cross trading north of 87.50 and given this history and the fact that the AUD/JPY has recently crossed this threshold again, whether it will be different this time?
The cross traded over 87.50 at a number of “interesting” points for the broad market: Early September of 2008, late April of 2010, late April of 2011 and mid-March 2012 (see chart below).
A look back
The Japanese had a real estate bubble collapse in the early 1990s. They also had/have a banking system crippled with toxic debt as a function of excessive speculation. Without going into mind numbing detail, the Bank of Japan decided to aggressively cut rates and engaged in Quantitative Easing measures for the better part of the past two decades in an effort to reflate their economy.
From August of 2006 until it double topped in July/November of 2007 the Aussie/yen cross was above 87.50. It got as high as 106 in summer of 2007 (ah…..the good times) and then cracked a bit (subprime is an issue) only to recover going into the end of 2007 (subprime is contained). The week after Bear Stearns was ushered into an arranged marriage with JP Morgan in March of 2008 the Aussie/yen cross traded down to 90.
When the markets (erroneously) believed that Bear Stearns was a “one off”, the cross began to climb higher again, moving up to almost 103 by July 4, 2008. Whistling past the graveyard?
That summer everything changed. If you’re reading this, chances are you probably have some painful memories as things got weird.
The Aussie/yen cross fell from around 104 in summer of 2007 to about 56 in early 2009, more than 46%.
Over the same time frame the S&Ps fell from 1425 to 670, a decline of more than 50%. Though not as dramatic, the S&Ps fell significantly shortly after the other times the Aussie/yen crossed above 87.50 (see chart below).
The bottom line is the Aussie/yen cross corresponds very well with risk appetite (or lack thereof) and at present it may be cause for concern.
|
7-Jul |
8-Sep |
10-Apr |
11-Apr |
12-Mar |
12-Dec |
|
|
Market |
|
|
|
|
|
|
|
Aussie/Yen cross |
107.5 |
89.75 |
87.2 |
88.5 |
87.4 |
88.3 |
|
S&Ps (cash) |
1525 |
1260 |
1220 |
1365 |
1410 |
1425 |
|
Nasdaq |
2700 |
2275 |
2530 |
2870 |
3090 |
3000 |
|
Crude Oil (WTI) |
77.2 |
119 |
87 |
114 |
110 |
87.5 |
|
Silver |
13.6 |
13.75 |
18.25 |
49.85 |
37.1 |
32.5 |
|
VIX (cash) |
17 |
23 |
16.7 |
14.75 |
14.5 |
16.7 |
|
Dollar Index |
79.85 |
78.25 |
80.15 |
73 |
79.1 |
79.55 |
|
Euro |
138.75 |
148.5 |
137 |
149.25 |
132.95 |
132 |
|
Aussie/USD |
88.7 |
84.6 |
92.85 |
109.2 |
107.25 |
105 |
|
Yen/USD |
81.75 |
91.7 |
99.3 |
117.45 |
118.8 |
119.25 |
|
Drawdown following breach of 87.50 |
||||||
|
Aussie/Yen cross |
56.5 |
72.5 |
74.1 |
76.5 |
|
|
|
S&Ps (cash) |
670 |
1025 |
1125 |
1275 |
??? |
|
|
Nasdaq |
1295 |
2100 |
2340 |
2750 |
??? |
|
|
Crude Oil (WTI) |
38 |
67 |
77 |
77 |
??? |
|
|
Silver |
8.75 |
17 |
26.25 |
26.5 |
??? |
|
|
VIX (cash) |
85 |
41 |
43 |
26.7 |
??? |
|
|
Dollar Index |
89.7 |
88.8 |
80.4 |
84.25 |
??? |
|
|
Euro |
125.5 |
118.75 |
131.4 |
121.5 |
??? |
|
|
Aussie/USD |
59.75 |
82.03 |
93.02 |
96.15 |
??? |
|
|
Yen/USD |
115 |
121.1 |
132.65 |
129.7 |
??? |
|
|
|
|
|
|
|
|
|
|
Peak to Trough |
|
|
|
|
|
|
|
Aussie/Yen cross |
-37.05% |
-16.86% |
-16.27% |
-12.47% |
??? |
|
The world changed after the events of 2007-2008. Risk markets, on average, do poorly in the months following the Aussie/yen cross trading above 87.50.
Is it different this time?
Don’t bet on it. Central Banks are meddling with far greater frequency in the post Lehman Brothers/AIG/Fannie/Freddie world, but eventually markets have a way of finding the pain.
Draw your own conclusions, but forewarned is forearmed. The VIX, Dollar Index, and yen all tend to have an inverse relationship with risk market performance, and volatility in general tends to go up a whole lot faster than it comes in.
Consider the Aussie/yen cross a street light. The light either just moved from green to yellow or perhaps it moved from yellow to red. It can be dangerous to run red lights.
