Comment 41: How oil price gyration has triggered the unwinding of yen carry trades that in turn has induced the global stock market debacle.
Recent global equity market turmoils have raised wide spread concern since from time to time such stock market debacles do foretell coming recessions, though many times stock markets do not have the wisdom to pierce through the veil separating the present and the future; there is a joke going around to say that stock markets have predicted Y out of X recessions with Y much larger than X. Nevertheless it is important to investigate what is the cause of this globally coordinated turmoil in the markets to see whether the event is telling us anything significant about the global economy.
Many observers have pointed out that the global stock market turmoil is induced by the unwinding of yen carry trades, since the sharp drop of US Dollar against Japanese Yen, a tale-telling sign of unwinding yen carry trades, coincided with the global stock market debacle. Others have objected to this observation by pointing out that mere synchronization of two events does not tell which is the cause and which is the consequence. There are also some who insist that the Chinese stock market's tumble has triggered everything, thus reinforcing their belief that when China sneezes, the whole world catches pneumonia; such a view can arise either from an extreme China phobia or from a jingoism China style. In this comment we present evidence that the origin of the whole turbulence is the recent sharp rise of crude oil price. Rising oil price makes oil producing countries rich again. As those oil producing countries rush back to US markets to buy up Dollar denominated debt instruments, the long term interest rate in US falls by a significant amount. The falling long term interest rate then induces a portion of yen carry trades, which have been installed at the high points of Dollar, to unwind, putting downward pressure on the value of Dollar against Yen. When Dollar softens against Yen, the speculative part of yen carry trades that has borrowed yens to buy global stocks at the market highs is gravely endangered. When those very speculative and ill timed yen carry trades unwound by selling off their stock holdings at the same time paying back borrowed yens (equivalent to selling Dollar for Yen), global stock markets tumbled suddenly and simultaneously forced Dollar down further against Yen, endangering more yen carry trades and forcing them to unwind. Thus a vicious cycle of falling Dollar and tumbling stock prices is formed. This analysis is further reinforced by observing the behavior of the Tokyo stock market. One needs yens (not dollars, euros or yuans) to buy stocks in the Tokyo market, so the Tokyo market is not directly entangled with yen carry trades. With the Tokyo market stagnant in recent months, it is also not a favorite place for global hot money to speculate. Exporter heavy Tokyo market will only come down, when the players see Yen moves up or US stock market come down, from the fear that US consumers will buy less made in Japan products. That is why the Tokyo market has played the role of the laggard throughout this global debacle.
In the graph at the right the daily crude oil price (WTI) are plotted as red dots, the yield of 10 year US Treasury Note as green dots, the value of Dollar vs. Yen expressed in units of Yen/Dollar as blue dots, and SP500 index as purple dots. The scale of crude oil is upside down; the lower the graph goes, the higher crude oil price becomes. To remind readers of this unique convention, the scale of crude oil is written out explicitly at the left of the graph. Through December of 2006, we can see the gradual fall of crude oil price toward $60 per barrel (the red curve), and the gradual rise of the yield of 10 year T. Note (the green curve) due to less oil money flowing into US treasury market. A s the treasury yield rose, yen carry trades had pushed up the value of Dollar (the blue curve) steadily. In January of 2007, crude oil price dived further toward $50 per barrel, and with a short delay the treasury yield quickened the pace of its upward march. Dollar was pushed up at the initial stage of this rise of treasury yield, but the rise of Dollar stopped after the middle of January due to the wide spread expectation that The Bank of Japan was going to raise Japan's interest rate. As the price of crude oil has started to rise sharply after the middle of January, the treasury yield has started to fall with a slight time delay. At the beginning of this fall of the treasury yield, there were no noticeable unwinding of yen carry trades. That lull was due to the lack of installation of yen carry trades during the latter half of January. However as the treasury yield has continued to come down, the unwinding of yen carry trades that had been installed around 120 Yen per Dollar was inevitable. This unwinding was realized when Asian markets warmed up after the lengthy lunar new year holidays. When the first wave of unwinding came, Dollar fell against Yen. This apparently panicked the players that had borrowed yens to buy stocks at various markets around the globe. Chinese markets, due to their physical locations, opened before European and American markets, so they were hit first. As time went by, European markets, followed by American markets, opened one by one and all are hit with the frenzy of selling stocks to repay the borrowed yens. That probably was the picture of this global debacle.
This global debacle shows vividly the power of the crude oil price as discussed in Comment 38. The ferocious speed of the unwinding of yen carry trades is analyzed in Currency and Gold Update (Jan. 31, 2007). As the prospect of US stock market, we remind readers of Comment 2 titled “Stock Markets Dance Around the Real Economy.” US economy has definitely cooled down during the course of 2006, and is going to continue with the sub par pace of growth for a while as discussed in Comment 38. The overly euphoric rise of US stock market in the period from the middle of 2006 until this debacle is apparently not warranted. This debacle is only pulling the stock market back to the reality. As long as Japan is keeping its interest rate low and Dollar unreasonably strong, yen carry trades will persist. As the consequence, violent gyrations of stock prices will also be the way of life. However, if we take a long term view and average out those stock market gyrations, the average performance of stocks will match the growth of the actual economy.