We all saw the china sell-off ripple through the world today, shaving 3.5% of the S&P500.
As everyone knows, there's been a lot of money sloshing around. Many know that a lot of that liquidity was provided by the carry trade, with funds borrowing in yen to make purchases elsewhere, including in the US. Those activities pushed the yen even lower, and roughly speaking, made it seemingly more attractive for the next fund to borrow in yen, to buy in dollars.
The Economist is looking very smart today, having run this article on Feb 8, 2007, with the title:
"Japan's currency, Carry on living dangerously. Speculators and low interest rates have helped cheapen the yen, putting the world economy at risk."
The Economist thinks the yen may be undervalued by 40% and notes in the article that according to "record net “short” positions in yen futures on the Chicago Mercantile Exchange...estimates of the total size of the carry trade range as high as $1 trillion." that's a lot of money that's relying on an un-appreciating yen.
I think there were two very important news items today.
1) No one has identified the reason behind the sell off, which simply says that we don't know what might be next and how people might react. The unknown unknowns just increased, and the risk premium just went up.
2) But the most important news item isn't the 3.5% drop in the S&P 500. It's the the fact that we saw yen based trades were being unwound - people were buying Yen to cover the carry trade. As far as I can tell, the yen appreciated less than 2.5% on tuesday, and opened weaker Wed Feb 28th - looks like we dodged a bullet today because the Japanese government reports showed a drop in industrial production and retail sales - if those reports had been different..
What happens over the next week will be very telling. If some good news about Japan's economy comes out, you could see the yen appreciate. And if bad news happens in the US, then certain funds might have to unwind their yen borrowings, which would also drive up the yen. And either of these could drive the yen to rise significantly, like a stock when the shorts need to cover. In 1998, the yen appreciated 13% in a very short period of time, the carry trade was hurt, and it wasn't pretty. A repeat could dry up a ton of liquidity, and that could lessen demand for shares around the world. And a few funds that were reliant on the carry trade could blow up, triggering more supply. That would be bad for equity prices everywhere.
Watch the yen, to find out what's going to happen to the US stock market.