The Bulls' Best Friend Returns

After an 18-month exile, the bulls are coming out of hiding as more signs point to an improving economy and a stock-market rally: The Chinese growth story appears to be real. Inventory liquidation looks near an end. Oil, copper and lumber have bottomed, home sales are rising and Wells Fargo beat its numbers.

There's an even better reason to be buying stocks: An old friend with a money machine is coming back, and he's ready to slay the bears at every turn by pumping up stocks, commodities and credit instruments.

This old buddy isn't found in economic textbooks, and is only marginally acknowledged by central bankers. He'll lend you $1 million at almost zero interest, and then demand only $900,000 in repayment. You can just as easily borrow $500 million or a $1 billion because he has very deep pockets.

This friend sounds fantastic and magical, but he's real. He's been used by hedge funds and big investors for years, and was a major cause of the pre-Lehman global stock rally and the American credit bubble.

This friend, called the "yen carry trade," is amazingly simple: You sell Japanese yen and buy just about anything else: euros, mortgage-backed securities, stocks or Australian dollars. The Japanese officials are usually very cooperative in this process by keeping interest rates near zero and debasing their own currency.

As a positive impetus, the yen carry trade took shape after 2004, accelerated in 2006 and 2007, and peaked in July 2008. When asset prices plunged last year, investors dumped positions to repay their debts, which meant buying yen. Investors who still owed money in the Japanese currency saw their liabilities rising, and also rushed to dump assets. As in most leveraged situations, the unwind was violent and self-reinforcing.

No one can measure the true size of the yen carry trade because it takes place in an over-the-counter market between thousands of participants globally rather than a regulated exchange. However, we know it was huge, based on a lot of anecdotal evidence and the strong inverse relationship between the yen and stocks in recent years.

This shows the euro versus the yen since 2004. When it rises, the yen is going down...

 ... closely mirroring the S&P 500, and most stock indexes in general ...

Source: Yahoo Finance

Many traders purchased yen to exploit the turmoil of the last 18 months, profiting from the pain of other people unwinding positions. This created an unnaturally strong demand for yen that looked a lot like a bubble of its own. The first reason to view the yen as a bubble is its appreciation ran counter to economic fundamentals. In this case, the yen rose despite a collapse in Japan's trade surplus and industrial production. Second, there is no shortage of yen thanks to Tokyo's determination to spend its way out of recession. (As was the case with real estate and tech stocks, supply often rises just as a bubble is ending.) Third, the demand for yen was artificial and created by a mechanical process rather than economic reality. This often drives the final stages of a bubble, and is analogous to developments in the U.S. housing market in 2006 and 2007, tech stocks in the late 1990s or Latin American debt in the early 1980s.

Like all bubbles, the yen bubble was waiting for the inevitable pinprick. It came in mid-February, when Finance Minister Shoichi Nakagawa appeared drunk at a press conference. Since then the yen has fallen more than 10 percent against the euro and shows no signs of regaining its footing anytime soon.

Next Stop 150?

(Euro/Yen, Daily Chart)

Source: FXStreet.com

 

In fact, the yen's rally was running out of steam even earlier. The waning momentum can be seen in the MACD line at the bottom of this chart. It rose even as the currency pair continued to fall early this year, an example of what technicians call "bullish divergence." This is a powerful reversal indicator that also appeared before oil peaked last summer and the stock market crashed on October 19, 1987.

Yes, the U.S. is repeating Japan's mistakes, but we won't feel the harmful effects for years. The key story now is that the yen has a one-way ticket into the abyss, stripping the bears of a key weapon in their battle against the stock market. Even if there are good reasons to be pessimistic, the vehicle to express that negativity is broken. If the yen goes into freefall -- as almost everyone expects -- the carry trade could return, with hugely bullish implications in coming months.