For the last year, one of the few financial instruments actually heading north has been the yen. It has been that way because it has such a pathetic interest rate associated with it that no one wants it even when times are good.
This causes it to be sold off and other higher yielding assets bought in good times. However, in bad economic times like we've had this past year, the yen has been a great place to be. Why? Investors run to beaten down assets in bear markets when most things are sliding off the face of the earth.
And there's not hardly a more beaten-down asset out there than the yen. It's been one of the most oversold financial instruments of any market, not just the currency market.
So the big hedge fund strategy has been to be short the U.S. stock market and long the yen. And it's been a great investment up until right now.
Why now? For a couple of important reasons. Let me lay them out for you.
The first bell that went off for me was the extreme reading on the VIX (Volatility Index).
The VIX shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both call and put option contracts.
The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge."
VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty. Values below 20 generally correspond to less stressful, even complacent, times in the markets.
Like the VIX, the yen also has been a fear gauge. It prospers when times are uncertain and stock markets are down.
Extreme VIX readings show that the fear in the stock market may have gotten to levels that are a bit overdone, and so a bottoming is near in the stock market. When stocks start to head upward, investors come out of the risk-aversion mode they had been in and back into risk-seeking mode.
So they sell off the yen and go back into stocks.
On Friday, the VIX registered a reading of 42, which is higher than we've seen in years and years. So, this is the first bell that went off and alerted me that the yen trade is just about done.
The second bell that went off for me has been all of the recent happenings in the markets. For instance, 150-year old companies have been blowing up (Bear Stearns, Lehman Brothers), and government-sponsored entities have as well (Fannie Mae, Freddie Mac). The government even had to go in and save one of the largest insurers in the world, AIG.
When markets are in such an extreme, rare frenzy such as we're seeing now, historically, that's indicative of a bottom in the stock market.
After all, the fear is always the greatest at the bottom, and there's always some very reasonable catalysts for that fear too. We've never seen more real catalysts in the market than what we've seen most recently.
The third and final bell that has gone off for me is where we are in the economic cycle (or what some refer to as the business cycle).
Right now, what do we have going on? Stocks are down overall. Commodities are down overall too. And bonds are heading higher overall. When this happens, the economy has dipped into either an economic slowdown or recession. That's why money has such a defensive posture at this time.
However, what follows is the trough of the economic dip, and that's when money starts to run out of bonds and back into stocks. We are about to enter that phase.
When this happens, those big money managers will be buying stocks and selling the yen (much like they did on Thursday and Friday of this past week).
While the market will have its ups and downs throughout this process, you're going to start to see more selling of bonds and repurchases of stocks over the coming months. When this happens (and it is just in the beginning stages now), you're going to see the yen lose out to higher-yielding currencies.
In particular, you will likely see the yen get sold off against the Australian dollar and the U.S. dollar. The Aussie dollar fits the mold of the high yielders. The U.S. dollar does not right now. So why would it prosper against the yen?
Because there's more trade flows that goes on between Japan and the U.S. than there is between Japan and any other nation. So, many major Japanese corporations that are huge hedgers of their currencies (Toyota, Sony, Honda, etc.) will shift their positions to protect themselves as well and probably even profit from it as a secondary benefit to their hedge. (The first and main benefit is simply to keep the exchange rate from eroding their profits).
So between the VIX, the recent "blow ups" of age-old companies, the government stepping in to save companies and pumping billions of dollars into the market along with other central banks of the world doing the same, and where we're heading in the business cycle, all of these are not "yen friendly." They are friendly to the risk seeking assets out there which are stocks and high-yielding currencies, firstly, and then later on in the cycle commodities will once again perk up too.
If the U.S. government and major central banks of the world are successful (and history shows us that group inventions work), then you will see a stock market bottom forming and a "yen top" forming now.
So you will see currency investors buying up AUD/JPY (Australian dollar vs. the Japanese yen) and USD/JPY (the U.S. dollar vs. the Japanese yen). You may also very well see the U.S. dollar suffer against many other currencies, but it should hold its own vs. the yen.
There's a good chance that almost anything bought against the yen will go up in the near future, but these two currency pairs stand the biggest chance of success in my book.
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