Like teachers with unruly kids, economists despair about currencies – exchange rates keep disobeying their macroeconomic discipline. And rules often change. Many traders stopped looking at current account balances as a means of explaining currencies following the dollar’s rise in the 1990s. Instead, relative interest rates became the focus. This gained in popularity with the growth of the carry trade – investors borrowing in low-yielding currencies, such as the yen, and investing in higher-yielding ones.
Whether that approach survives this month’s rapid unwinding of carry trades remains to be seen. Already, the depreciation of the dollar suggests a revival in the perceived importance of trade accounts. But recent equity market volatility has revealed another pattern to watch: when the US stock market falls, the yen rallies and vice versa. While more extreme in the past three weeks, this correlation has been high for six months, with the S&P500 and the yen moving inversely on 65 per cent of trading days.
The yen, it seems, is a barometer for the appetite of US equity investors. That should be ridiculous – the fundamental value of each asset class is not determined by the same factors. Links can exist between a country’s exchange rate and its equity market if, for example, many companies are active abroad. But the strong yen has come to embody the antithesis of financial excess.
Given the yen’s role as a funding currency for investments in other assets, this might appear sensible. But the reality is that hedge funds account for only about half of carry trades and, in any case, tend not to invest in US equities. Japanese savers – the other main sellers of yen – rarely play any stock markets. Both these groups will probably determine the direction of the yen in the medium term, but not the fate of the US equity market.