This is the chart of the dollar/yen exchange rate in purple. And the Nasdaq is in orange.
As you can see the two have tracked closely, and it’s no coincidence.
This reflects the “carry trade” — the borrowing of yen for (effectively) free, converting that yen to dollars (dollar/yen goes up), and investing those dollars in the highest quality dollar-denominated assets (U.S. Treasuries and the big tech oligopoly stocks).
So, in the chart above, the rise in dollar/yen and rise in stocks are products of abundant global liquidity promoted by Bank of Japan monetary policy.
On that note, let’s revisit an excerpt from my note last week:
“With the Bank of Japan telegraphing the beginning-of-the-end of QE (a plan to taper global liquidity), the (carry) trade is reversing, as you can see within the white frame in the chart above.
And with that, the risk rises of global liquidity swinging in the direction of too tight (i.e. a liquidity shock). The question is, will the Fed surprise markets next week with a move, or will the market have to force the Fed’s hand?”
Fast forward to yesterday: The Bank of Japan did indeed lay out the plan to reduce the size of the program that has supported the Japanese government bond market, and other key asset markets around the world (including U.S. Treasuries) for the past decade-plus. They also raise rates, and signaled more to come.
And the Fed did not surprise markets with a move (a counter-punch) but rather chose to hold rates unchanged (at historically high real rates) for the twelfth consecutive month.
With that dynamic at work, here is an updated look at this Nasdaq vs. dollar/yen chart …
As you can see to the far right of the chart, the reversal of the carry trade continues in dollar/yen and that suggests it will continue in the Nasdaq (in stocks).
That would mean a break of this big trendline we’ve been watching in the Nasdaq (and a similar line in the S&P futures).
As we discussed earlier this week, this big trendline represents the trend from the October lows, which was marked by Fed signaling that the tightening cycle was over.
The trajectory of the trendline represents the view that financial conditions will be easing. But, again, the policy expectations that induced the trendline have not materialized.
So, back to the question in last week’s note: Will the market have to force the Fed’s hand?
It appears so.
If we get a weak jobs report tomorrow, and if stocks break down, expect the Fed to line up the media tour for committee members to communicate certainty on a September cut.
Moreover, they should float the possibility of cutting by 50 basis points. Notably, in five of the past six rate cut series the Fed started with a half point cut.