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The Yen Carry Trade: A Delicate Dance of Markets

What Could Propel Stocks Further Upward? Despite a small drop in stocks last week, the three main drivers of the market rally remained intact: continued disinflation as indicated by the CPI, economic data suggesting a soft landing scenario, and indications from the Fed that interest rate hikes might be nearing their end.


However, merely confirming these factors isn't enough to elevate stocks since the market has already accounted for them. This makes the market susceptible to minor setbacks leading to declines, as observed over the past couple of weeks. So, what could rekindle the rally? Four potential catalysts are:


1. A Slight Drop in Treasury Yields: A moderate decrease, particularly in the 10-year yield, could bolster the market and make a case for a valuation of 20X, up from the current 19X. This might result from the Fed confirming an end to rate hikes or consistent economic data paired with declining inflation.


2. Earnings Surpassing Expectations: If the potential for valuation expansion is tapped out, then rising earnings could be the key. If projections for the S&P 500's 2024 EPS rise from the current $240 to around $250, it sets a realistic target of 4,750. This week's earnings updates from major companies like Home Depot $HD, Target $TGT, Walmart $WMT, Estee Lauder $EL, and Applied Materials $AMAT will be crucial, especially the NVIDIA $NVDA earnings on Aug. 23, which previously sparked a summer rally.



3. Shift in Market Sentiment: The unexpected hero of the 2023 rally was the negative sentiment which, when unfulfilled, led to a surge in stock purchases. If the market plateaus or slightly retracts, a more pessimistic sentiment could create a perception gap, potentially leading to a rally.



4. Unexpected Positive Macroeconomic News: Developments like a thaw in U.S.-China relations, substantial economic stimulus from China, or a halt in the Russia/Ukraine conflict could unexpectedly boost the market by reducing global recession risks.


This week, there are a lot of eyes on China. Speculations suggest that potential developments in China could negatively impact not only Asian stocks but global markets as well. This concern follows the recent event where Country Garden, one of China's leading real estate developers, failed to pay an interest of approximately $22.5 million on its bonds due to overwhelming debt. This could be yet another early sign that a credit event is coming.



Despite the Fitch downgrade of the US credit rating, we haven't seen a significant reaction like we did in 2011. As I mentioned in my previous post, many investors are overlooking this downgrade because they believe the role of U.S. Treasuries in the global financial system remains unchanged.


I find it easier to focus on immediate concerns rather than potential future issues. Given the current situation, it's understandable why the bulls are optimistic, which is why all three components of the RISKSIGNAL are positive this morning, suggesting it might be a good time to consider taking on some risk. If you are a buyer here, I advise incrementally buying at 50-100 bps at a time, on down days, rather than investing it all at once.


Sectors such as utilities, healthcare, and staples are hinting at a rebound after facing significant undervaluation. However, their modest upward trajectory often struggles to last beyond a few weeks. Should these defensive sectors begin to accelerate, it could serve as a precursor to increased market volatility.


I'm also concerned about the retail sector. The upcoming July retail sales data will provide more insight, but the current outlook for retailers isn't promising. It's hard to support this sector given current conditions. This is especially worrisome since consumer spending and the services sector have been the pillars supporting our economy. If they falter, the overall economic situation could deteriorate significantly.



The Yen Carry Trade


In the vast ocean of global finance, there are many currents that guide the direction of your investments. One such current, often overlooked but of paramount importance, is the Yen Carry Trade. Recently, a ripple in this current has caught my attention, and I believe it's crucial for us to understand its implications.


The Yen Carry Trade: A Simple Analogy


Imagine you're a savvy entrepreneur in a town where one bank offers loans at 0% interest, while another bank across the street offers a savings account with a 4% interest rate. You'd borrow from the first bank and deposit in the second, pocketing the difference (or "spread"), right? This is the essence of the Yen Carry Trade.


Historically, the Bank of Japan has kept its interest rates near zero, much lower than its global peers. Institutional investors borrow in Yen, convert it to another currency (like USD), and invest in higher-yielding assets. It's a financial dance that's been going on since the mid-2000s. In simpler terms, the yen carry trade allows investors to borrow money at low costs (cheap leverage) to invest in financial assets. They can either 1) Earn a profit from the difference in interest rates or 2) Increase their investment in specific stocks or assets using the borrowed funds.



Why This Matters Now


A couple of weeks ago, the Bank of Japan made a subtle move, allowing the yield on the 10-year Japanese Government Bond (JGB) to rise above 0.50%. This might seem like a small step, but in the world of finance, it's similar to changing the rhythm of a song. If the cost of borrowing in Yen rises, the dance becomes less fun (less profitable), and some dancers will leave the floor. The assets they were invested in, like AI tech stocks and Treasuries, will likely face selling pressure.


How Should You Position If The Trade Unwinds?

If this carry trade starts to unwind significantly, the crowd will panic. Defensive sectors such as utilities, staples, and healthcare become the metaphorical tents where investors might seek shelter. To put it simply, while this beta rotation strategy does not guarantee you profits, it's likely to decline less in value compared to highly valued AI stocks and the S&P 500. This approach lets you stay invested without being as exposed to the downsides of more volatile assets.



Could This Lead to a Market Correction?


On its own, the Yen Carry Trade's reversal might not trigger a market selloff. However, when combined with other market pressures, it could be the tipping point that leads to a significant market drop, potentially more than 5%. The last time this trade unwound, it stirred the waters of volatility. If it happens again, and Treasury yields spike, it could put a damper on stock valuations and raise more concerns about regional banks.


Final Thoughts


Markets thrive on stability. The current narrative is positive, but an accelerated unwinding of the Yen Carry Trade could disrupt this harmony. It's like a sudden key change in a symphony - unexpected and potentially jarring.


For now, the situation seems under control. But rest assured, we're keeping a close ear to the ground. Put simply, if things begin to shift, I'll definitely raise the alarm and make sure everyone is aware.


If the Ivory Hill RISKSIGNAL turns red, we will not hesitate to increase our cash levels as sticking to our rules at this point in the cycle is more crucial than ever.


And remember - the one fact pertaining to all conditions is that they will change.


Feel free to reach out to me and use me as a sounding board.


Best regards,


-Kurt


Kurt S. Altrichter, CRPS®

Fiduciary Advisor | President

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