If The Equity Markets Sell-Off, What Does It Mean For the Yen?

As I’ve mentioned in many previous articles, we focus a substantial amount of time on identifying correlations between markets so that we can attempt to take advantage of multiple sectors in the event any one market makes a significant directional move.  Case in point:  the “carry trade” that so many took advantage of through the first few months of the year.  As equities were on a tear to the upside through the first six months of the year, we saw funds flowing out of the Yen at an alarming rate.  Essentially, traders were taking money out of the Yen to buy equities, a classic “risk-on” trade.   To get specific on how closely these two moves were correlated, from the beginning to November 2012 until mid-May of this year, the E-mini S&P 500 was up approximately 21% while the Japanese Yen was down over the same period approximately 23%.  To be clear, I am not implying that this is some sort of aberration that I’ve uncovered.  As a historically “safe-haven” market, the Yen typically does sell-off in times when the equity markets are strong and rally in times of uncertainty.

With that said, the seemingly obvious answer to what will happen to the Yen if we have a sell-off in the equity markets would be that the Yen would rally.  Similar to the equity markets giving back some of what they gained throughout the course of the year, a logical expectation would be that the Yen would see similar retracement in the opposite direction.  In fact, a few months ago I wrote about the unwinding of the “carry trade”, arguing at that time that we would see the Yen go higher as a result if and when the equity markets broke.  Taking a look at the charts below, now I’m not so sure that will happen.

There are a few areas of note when looking at these two charts.  The first of which is that you can plainly see the correlation that we referred to earlier through mid-May of this year.  The Yen making lows right at the time that the Emini is making highs.  If the graphic went back a few months further, you would see the chart of the Emini steadily moving higher as the Yen made its way below par.  However, take a close look at how these two markets have moved since mid-June.  The two markets have actually moved in tandem over the past 4 months.  Both markets sold-off sharply at the end of June, rallied through the month of July, sold off in the month of August and have moved higher in the month of September.  This is quite a difference in correlation from the first half of the year to say the least.

Because the inverse correlation that we’ve come to expect from the traditional “risk-on” equity market and the “risk-off” Yen is not holding true in recent months, I’m not too convinced that we should expect it to hold if we do see a sell-off in the Emini over the last few months of the year.  With the Emini showing some signs of weakness both technically and fundamentally, the question becomes should you buy the Yen if you are bearish the equity markets?

Despite history telling us otherwise, I believe at this time that if the Emini sells off that the Yen will actually sell off with it.  Although that may be counterintuitive to many traders, the correlation breakdown that we talked about earlier is not the only reason I feel this is likely.  In addition, the most likely reason (in my humble opinion, of course) that we may see a significant sell off in the equity markets over the last few months of the year would be the Fed announcing plans to taper.  This type of an announcement is obviously not a certainty, but it is in the cards.  And if the Fed does announce a reduction to the current printing press that has been in effect up to this point, we will most likely see the US dollar go higher.  The US dollar moving higher is bearish for all currencies tied to it, not excluding the Japanese Yen.

This piece is simply a word of caution for those that are looking to take advantage of a potential unwinding of the aforementioned “carry trade”.  Prematurely entering into a short equities/long Yen position in an attempt to take advantage of the “carry trade” unwinding may lead to many traders giving up portions of their gains from the reciprocal trade earlier this year.  Although these two markets worked together to get where they are now, that does not mean that they will work together to get back to where they were.

Questions or comments?  Contact Trent directly at 312-756-0932 or at twagner@tradewithfox.com.  For a free trial of Trent’s newsletter, The Weekly Options Trading Report, click on the link below and select “Options Newsletter” from the dropdown box on the subject line.

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