Wall Street May Get What It Wishes For

By: David Yu | Fri, Sep 14, 2007
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Lately, it's almost impossible not to be reminded of the rising probability of a recession by the Wall Street cheerleading squad, which used to dispute vehemently any notion of a recession just a couple of months ago. As it gets closer to the FOMC meeting next week, the R word has been thrown around by experts and Wall Street pundits more frequently than the re-run of Frasier. They're apparently hoping the onslaught of this recession campaign would sway the Fed to cut its overnight lending rate more drastically. The market, nonetheless, appears to have already priced in 0.25% rate cut and moved on since the end of August. Unless the Fed does something unexpected, the market seems no longer driven by the highly anticipated rate cut. The revival of yen carry trade may be the driving force behind recent rally.

I mentioned in Rally by Carry Trade on 9/11/2007 that recent intraday charts of the SPX (S&P 500 Index) and the Dollar-Yen Exchange Rate were moving almost tick for tick. The longer term chart also shows synchronized movement between the SPX and the exchange rate. I use 11-day simple moving average on Chart 1 to smooth out the curve of the daily % change of the SPX and the yen. They show almost identical pattern since the end of August (blue dotted box), when the intraday SPX reached above 1480 for the first time since 8/9/2007. What's interesting is that this is all happening while the Dollar's sinking like a stone against most other major currencies.

Chart 1

The Fed's Dollar Index against major currencies (Chart 2) plummeted below 7/24/2007 record low (76.7802) on 9/7/2007. It then went on to set consecutive new low records 4 days in a row from 9/7/2007 to 9/12/2007 (at the time of this writing). After falling below 80 in April, it appears that the Dollar Index had tried to hold its ground till mid June (yellow dot). Over the ensuing 3 months, and before the record breaking nosedive this week, other major currencies had actually depreciated against the Dollar. But, no other major currencies had lost more ground to the Dollar during that period than the Japanese yen.

Chart 2

This 3-month map of currency's appreciation (blue) and depreciation (red) against the Dollar (Chart 3 below) shows that, as of 9/12/2007, the Japanese yen (JPY) had depreciated 7.19% against the Dollar - more than the Euro (EUR), the British pound (GBP), the Canadian dollar, the Chinese yuan (CNY), and other major currencies.

Chart 3

While all the talk of recession and the Fed's rate cut have dropped the Dollar to the historic low, the demise of a president or a prime minister appears to have more devastating effect on its currency. Toward the end of August, when Japan's prime minister, Shinzo Abe, began replacing his cabinet members with old timers, the market obviously thought that might be his final act.

And, only days after President Bush told him, on the sideline of the APEC summit in Australia, that Japan's refueling of U.S. warships in the Indian Ocean has provided a vital service to the fight against terrorism, Shinzo Abe stepped down as Japan's prime minister on Sept. 12.

Some sources cited the primary reasons for Abe's resignation as health related and low approval rating. Chart on the right, shows 2007 timeline of Abe administration's approval (orange line) and disapproval (aqua line) ratings. Other sources, mostly from Japan and the rest of Asia, seem to place more emphasis on his relentless support for Bush. Just one day after his one-on-one meeting with Bush at the APEC summit, Abe said he would resign if the

Parliament voted not to renew a law that allows Japanese armed forces to supply fuel to U.S. warships.

Despite his personal health issue, scandals within his administration, low approval rating, etc. that might've contributed to his final decision to resign, Abe's demise is actually just a reflection of Japan's frustration over a stagnant economy. Japan's prolonged recession is further burdened with aging population, widening income gap, and growing national debt. Japan's national debt had grown to be approx. 170% of its GDP, which is the highest among industrialized nations. Each Japanese citizen is now carrying more than $5 million share of the national debt.

Since my January 22, 2006 article, Too Old to Rock 'n' Roll, Too Young To Die, the Tokyo Nikkei Average Index had gone from 15,696.69 on 1/20/2006 to 15,797.60 on 9/12/2007, for a change of 100.91 points, or 0.64%, over approx. 20 months. This measly annualized gain of 0.39% spoke volume of the undercurrent of Japan's socioeconomic problems. The only thing that's going for Japan is perhaps its currency devaluation against the U.S. Dollar. The yen devaluation has kept the Japanese exporters going, but it has done very little for domestic businesses and its people. This inequality in wealth distribution, by all means, further exacerbates the income gap. The yen's devaluation also translates to higher import prices. This means, among other implications, higher energy costs for an island nation that has little natural resources of its own.

Japan's businesses had once again started to trim back on capital investment, which led to the GDP decline of 0.3% in the April-June quarter, or the 1st quarter of this fiscal year.

For now, devaluing the Japanese yen becomes the lifeline that at least keeps the Japanese exporters afloat. And, its competitive devaluation against the US Dollar seems to form the carry-trade lifeline that keeps Wall Street speculators going. The problem is that, in its attempt to accommodate Wall Street's greed, the Fed may prescribe overdose of liquidity easing to a financial system that's experiencing more of a credit and confidence crisis than a liquidity problem. That would accelerate the Dollar's decline. And, in addition, if we should ever see a quarter of negative GDP growth, the Dollar may go into freefall.

The absence of risk premium covering this Fed's intervention risk as well as the US economy's recession risk makes recent carry-trade based rally extremely speculative and dangerous. But, then again, Wall Street may finally get what it wishes for.



David Yu

Author: David Yu

David Yu,
Davids Stock Market Chartmentary
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