Friday, March 25, 2011

Stock Markets Buoyed by G-7 Central Banks?

There's a cacophony of negative news in the morning press: dismal housing market; weak durable goods reports; Japan; Libya; and so on.

But the stock market continues to do well. In fact, at the market close last night, the S&P 500 is just 2.5% below than the multi-year high reached in last month.

There are lots of catalysts for the bullish tone of the market. However, yesterday's Financial Times carried an important reason that really hadn't occurred to me: the return of the "carry trade".

In simplest terms, the carry trade simply is a technique where investors borrow funds in low yield countries (like Japan) to invest in other markets, including equities and commodities.

The risk in the carry trade is currency. At some point the investor needs to repay the funds, but if the currency markets don't cooperate the investor could lose money.

Earlier this month, when the central banks of the G-7 actively intervened in the currency market to slow the appreciation of the yen, they effectively put a ceiling on just how much the yen could appreciate. This could unleash huge dollops of liquidity into the world markets.

Here's the relevant paragraphs from yesterday's story:

All that, though, could be about to change if the belief that central banks have imposed a ceiling on the yen gains traction. And a return of the carry trade would have the potential to lift prices of risky assets – equities and commodities are already well into a bull run – even further, analysts say.

“There is another wave of global liquidity in the making, this time coming out of Japan. This liquidity will not stay in Japan and will boost asset prices elsewhere,” says Hans Redeker at BNP Paribas

The impact of currency intervention, if sustained, could have a similar effect to the US Federal Reserve’s preparations in the summer of 2010 for a second round of “quantitative easing”, its huge bond-buying programme to kick-start recovery. The Fed’s action lifted shares and weakened the dollar.

“This time it will be the yen funding another rush into global assets,” says Mr Redeker. “We buy aggressively into risk and see the yen moving lower.”