Sterling And Japanese Yen Moving In Tandem With US Equity Market?

Adrian Ash - Tue 04 Sep, 2007

Hazel Blears has been known to land a job helping to run the country no less! It just goes to prove how weird things can get if you're not careful. Put another way, "the correlation between GBP/JPY and the S&P 500 since the start of June 2006 stands at 95.8%," as Simon Derrick reports for Bank of New York Mellon. Regular readers might need to read that sentence twice to get over the shock; changes in the value of sterling against the Japanese yen have displayed a near-perfect correlation with the broad US stock market over the last year.

In our crazy, mixed-up world, anything is possible. David “Dave" Cameron might put an end to his "vacuous reforms" now that a leading Tory has finally grown the balls to speak up. Amy Winehouse might just make it through an hour of rehab. We may even come to care.

After all, Hazel Blears has been known to land a job – helping to run the country no less! It just goes to prove how weird things can get if you're not careful. Put another way, "the correlation between GBP/JPY and the S&P 500 since the start of June 2006 stands at 95.8%," as Simon Derrick reports for Bank of New York Mellon.

Regular readers might need to read that sentence twice to get over the shock; changes in the value of sterling against the Japanese yen have displayed a near-perfect correlation with the broad US stock market over the last year.

As ever, in short, the thigh bone's connected to the kneebone...but now with the neckbone in between.

"This, to us, sounds like as good a definition of a bubble as we can think of," says Derrick. Your editors here at The Daily Reckoning have called it a bubble in everything more than once, too. Borrowing cheap yen to buy the pound in your pocket, investment professionals the world over have bid up Wall Street stocks in their happy, hopeful, expectant frenzy.

"It is worth considering quite what happened at the end of the last great Japanese yen fuelled bubble," Derrick goes on, "back in the latter stages of 1998. Then, as now, the performance of sterling vs. yen had been moving in tandem with the performance of the US equity markets. Between April 1995 and October 1998 there was a 93.4% correlation between the weekly closes in GBP/JPY and the S&P500."

The S&P reached a peak in mid-July '98; the pound in your pocket hit ¥240 a few weeks later. The correlation then held tight "as the stock market crumbled," reports Derrick. "GBP/JPY dropped sharply to below ¥220 over a two-week period...[and then] with stocks falling again as September drew to a close, investors finally succumbed to a massive bout of risk aversion and decided to wind up all of their Japanese yen-funded investments. Over the course of one traumatic week, the British pound managed to drop from above ¥230 to below ¥200."

"What relevance do the events of nine years ago have to today?" asks the man from the New York Bank of Mellon. "Arguably," he answers himself, "the tenor of the carry trade this time around has been much longer." He ain't kidding.

Yen-denominated lending reached a total of $1,050 billion during the first quarter of this year, says the latest report from the Bank for International Settlements in Zurich. Lending in Swiss Francs – last and very much least amongst the world's top five currencies – added another $678 billion to the great global carry trade of investors borrowing cheap to buy higher-risk assets.

Now the yen and the Swiss franc have turned up, however, and so they have become the higher-risk asset. Higher-risk not to own, but to owe.

"Although history rarely repeats itself, there are distinct echoes of 1998 in some recent events," says Simon Derrick. "If events are playing out as they did then – albeit with GBP/JPY moving even more in tandem with the US equity market today than it did nine years ago – then it suggests that the current unwinding could still have a significant way to go."

The upshot for you and your money, gentle reader? Unless you're long – or short – of either the Japanese yen or US stock market, the trouble may seem as distant as Amy Winehouse booking into a hotel next door. It is noisy and ugly, perhaps, but more a public spectacle for the tabloids and Times, than a real danger to your health.

Thing is, however, your pension fund manager might just invite Winehouse round for a quick drink - or ten – at your house. According to a June survey by Watson Wyatt, the financial consultancy, more than four-fifths of UK fund managers running final-salary pension schemes "favour a significant exposure to potentially high-risk, high-return assets," reports the Financial Times. "The ideal proportion of high-return assets in their schemes was above 40%."

Perhaps one of these risk-toting fund managers runs a little of your retirement cash? All told, they run £70 billion between them – and being "long term" investors by definition, if not by sloth, they are unlikely to change their strategy now according to Graham Mitchell, a senior consultant at Watson Wyatt.

Indeed, one-third of the pension fund managers responding to his survey said they would continue to seek high returns "in any event".

Any event? Even the 25-standard deviation events seen by the numbers-monkeys at Goldman Sachs as the US stock market dropped 10% of its value last month?

Anything is possible, we guess. But prodding the edge of just what might happen could prove an expensive way for your fund manager to stick with stocks "for the long term".

Regards

Adrian Ash
For The Daily Reckoning

Adrian Ash is head of research at BullionVault.com the world's fastest-growing and best-value gold ownership service.

http://www.bullionvault.com/from/dailyreckon