A Real Yen for Stocks

02/27/2014 6:00 am EST

Focus: TRADING

If you’re feeling confused about why the stock market rises and falls daily in response to certain news events, David Moenning of StateoftheMarkets.com has a pretty simple explanation about its seemingly schizophrenic gyrations.

Let's see a show of hands. How many of you out there struggle from time to time to ascertain why Ms. Market is doing whatever the heck she is doing on a given day?

Monday was a perfect example of why the word logic is rarely used in connection with the action in the stock market. In short, anyone perusing the headlines or watching the economic data may have expected stocks to take a dive when the opening bell rang at the corner of Broad and Wall. So, what did stocks do on Monday? Oh, that's right; run toward new all-time highs, of course. Hmmm...

The News Wasn't Great
Before the opening bell, traders were treated to several headlines that may have caused the words "uh oh" to be spontaneously uttered. First, there was word that the Ukraine Parliament had tossed the President to the curb and that the folks in charge were talking about needing the equivalent of €25 billion to keep the country's lights on over the next two years. And hey, didn't the mere mention of a country needing a bailout once turn the market on its head?

Then there were the reports out of China. Stocks in Shanghai has been slammed for big losses (-1.74% to be exact) in response to word that Chinese banks had been tightening credit to developers during January. As a result, the yuan moved lower due to the fact that the reports suggested the government had actually engineered the weakness. The Chinese currency wound up heading lower for the fifth day in a row and is now trading at its lowest level since October. Uh oh, indeed.

In case you are one of those that doesn't put a lot of stock in the goings on in China, a recent survey of 51 CFOs from Europe and Asia asked the company heads to identify the biggest global risk factors to their businesses. The survey found that respondents saw weakening consumer demand as the top threat while Chinese growth was number two, and the economies of the emerging markets came in a close third. Oh, and 76% of the CFOs surveyed see Chinese growth falling below 7% in 2014.

Then came the Markit Services flash PMI for the US. The preliminary report, which is designed to indicate the state of the services sector, came in at 52.7, a far cry from January's reading of 56.6. Normally, this would be viewed as a disastrous report. However, as usual, the weather was a ready-made excuse.

The Response in the Stock Market Was...
Given the inputs from both overseas and here at home, one might have expected to see stocks decline at the open. Or at the very least, move sideways.

So, again, let's see those hands. How many were a little surprised that the S&P 500 spiked up 16 points in the first 10 minutes, erasing Friday's entire decline in the process? And then how many more were surprised—albeit pleasantly so—to see the venerable market index burst through the old highs and start to march to fresh all-time highs? Yea, that's what I thought.

When in Doubt, Look to the Yen
Admittedly, what we're about to discuss may sound a bit loony. However, when you find yourself in doubt as to the reason why stocks are moving on a given day, look to the yen. Yep, that's right, the Japanese yen is indeed a factor in the stock market these days.

The relationship is simple. When the yen weakens, the US stock market tends to rise, and when it strengthens, equities fall. The question, of course, is why?

The yen has always been a key component of something called the carry trade. This is where hedge funds and traders at the big bank trading desks first borrow money in yen and then turn around and spend the cash on risk assets. And for some time now, the US stock market has been the primary destination for those "carrying" their stock investments in yen.

All About The Carry Trade
So...anything that gives traders the idea that the yen will weaken—or correspondingly that the US dollar will strengthen—winds up being good for stocks. Wacky yes, but true.

And right now there are a handful of key macro factors that support the yen-carry trade into US stocks. First, is the economic recovery in the United States. Second, is the calmer political climate in Washington. In other words, the US still looks pretty attractive on a global macro basis.

Then there is a little something called Abenomics. The bottom line is that Prime Minister Abe's plan to wrestle his country from a decades-long bout with deflation involves a massive QE (bond buying) program. In case you're not aware, the BOJ is buying bonds to the tune of $78 billion a month, which due to the relative size of Japan's economy, is an even more powerful QE program than Ben Bernanke & Co's. Abe's stated goal is to double the monetary base and get some inflation going in the process. And if you remember your economics courses, this should cause the yen to fall. Which, in turn, further incentivizes the carry trade.

But Wait, There's More!
Now mix in the fact that the US Federal Reserve is in full-on "taper" mode with their own QE program, and you've got one whale of a reason to just keep on keepin' on with that yen-carry deal.

So, if you find yourself confused as to why stocks might be moving up (or down) for little reason, remember that traders have a real yen for US stocks these days!

By David Moenning of StateoftheMarkets.com

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