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Debt Deflation and the Japanese Yen

In our last post we discussed our views on deflation and how it will  be around  longer then most investors think.  Most people are stuck on the idea that hyper inflation is just around the corner and that you must be buying gold, most other commodities, and Asian stocks and at the same time short the US Dollar, Japanese Yen, US Treasuries, and US stocks.  Eventually this may be the right stance, but for now we think, along with the market, that it is the wrong view for the short and medium term.

The main issue stems from the idea that because the government has printed a gazillion dollars that we MUST have hyper inflation tomorrow.  The reality is that until that money is actually in circulation it will not cause inflation.  If you look at the financial situation of most banks it is obvious that not only are they not lending, but they are still so weak that they can’t lend.  Until they have rebuilt their balance sheets they will remain weak and unable to do any large scale lending on anything but bad terms.

Add to this the fact that consumers are saving more and more and you have massive debt deflation.  Consumers that are employed are paying down debt while the unemployed are unable to go into much more debt as credit card companies have curtailed their lending and the housing ATM is shut down.

As the global financial markets continue to deflate we have a few trends that are benefiting from this.  One that we have already covered is that of going long US Treasury bonds.  Another trend that we have shared with our subscribers is that of going long the Japanese Yen.  Long viewed as the funding currency for the carry trade , over the past 18 months the Yen has changed course and is now a safe haven currency.  Every time that investors have fled risky assets such as stocks and corporate debt then have flocked to the Yen.  As investors increasingly realize that the current threat is continued deflation and not inflation we think that they will gravitate out of stocks and into Treasury bonds and the Yen.

In the chart below (click to enlarge) you can see that since 1998 the Yen had been consolidating until breaking out back in March of 2008 as the financial crisis accelerated with the demise of Bear Stearns.  This breakout later pulled back before breaking out again and making a large move lower.

Japanese Yen 15-Year Weekly

yen-long-term-15-year-weekly-chart

As you can see in this chart (click to enlarge) the last two pullbacks have found support at the 50% retracement levels.  While we don’t think that Fibonacci levels have some mystical power, we do use them to find opportunities to buy pullbacks in a trend.

Japanese Yen 3-Year Weekly With Retracements

yen-3-year-daily-with-50-percent-retracements1


Finally as you can see in this daily chart of the last year (click to enlarge) you can see that we finally have broken out of an almost year long consolidation.  While not a perfect triangle it obviously contracted more and more until finally breaking out over the last few days.

Japanese Yen 1-Year Daily Chart

yen-1-year-daily-consolidation

Looking at the 15-year long term chart of the Yen we are expecting a move up to 114 and would not be surprised to see it make new highs at 120 in the coming months (If you are looking at the USD/JPY cross the levels would be 88 and 80).  Although anyone who is a macro trader is no doubt aware of this move we have found that most equity investors skip over currencies and fixed income themes, thinking that they have nothing to do with them.  The reality is that the currency and fixed income markets can give great signals for when risk is high or low and should be followed by all investors.

Happy Trading,

The Macro Trader

Dave@TheMacroTrader.com

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Debt Deflation and the Japanese Yen
URL: http://www.themacrotrader.com/2009/07/09/debt-deflation-and-the-japanese-yen/

The Carry Trade and Volatility

In our ETF based newsletter, the carry trade is one of the strategies that we employ. For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries. You short a low-yielding currency and go long a higher-yielding currency.

You can make money in two ways. You earn the “carry” if the currencies remain very stable, and neither move. You can also make money in this trade by being correct in the direction. For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar. The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates. Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007. As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69. If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces. Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility. While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets. We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well. On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts. The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean. When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out. On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX

rtm-jpmvxyg7

The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it was able to break out to the upside.

DBV and JPM G-7 VIX

dbv-vxy

Finally we have the DBV itself. As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it broke out to the upside.

DBV-Carry Trade ETF

dbv

Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting. If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis. While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

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and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: The Carry Trade And Volatility
URL: http://www.themacrotrader.com/2009/06/01/the-carry-trade-and-volatility/

EWY South Korea ETF

One of our current positions is EWY the South Korean ETF. We went long a few weeks ago in our model portfolio based on the trend, valuation, and economic characteristics of South Korean stocks.

EWY-South Korea ETF

ewy

Another factor that got us into EWY was the increasing number of Asian countries that have been coming up in our global stock model. Our global stock model looks at technical, economic, fundamental, and sentiment indicators to help find foreign stock indexes that meet our risk to reward criteria.

Apparently we are not the only ones to have found an opportunity in South Korea as the Oracle himself WarrenB apparently is getting long some South Korean stocks as well.

In order to catch our trades in foreign stocks as well as other asset classes like US stocks, bonds, currencies, and commodities then sign up for a quarterly or annual subscription to The Macro Trader weekly newsletter with frequent intra-week updates.

Happy Trading,

Dave@TheMacroTrader.com

GLD Gold ETF and SLV Silver ETF

We were long precious metals coming into 2009 as gold, silver, and even platinum were climbing higher.  Eventually we got stopped out as the group consolidated for the next three months.  The last two weeks gold and silver have been able to breakout of the consolidation and is once again in an uptrend.  We went long in out model portfolio last week and are currently looking to add to our position if the trend continues.

GLD Gold ETF

gld-gold-etf

SLV Silver ETF

slv-silver-etf

In order to catch our trades in precious metals as well as other asset classes like stocks, bonds, currencies, and other commodities then sign up for a quarterly or annual subscription to The Macro Trader weekly newsletter with frequent intra-week updates.

Happy Trading,

Dave@TheMacroTrader.com

A Simple SP500 Timing Model

We track hundreds of different economic, fundamental, technical, sentiment, and cycle indicators. Some are stand alone and only help us discern particular situations while others are full blown timing models that we use to get in and out of the market. Some are very complex with ten and even twenty inputs ranging from jobless claims, to put call ratios, to nickel, to the advance decline line. Essentially anything that we test that helps to give us an edge we use to some degree or other. As global macro traders we of course have several models for every market that we trade, as well as models that only point us to markets showing abnormal movement.

As of a few days ago we had one of our longer term SP500 timing models trigger a buy signal. This timing model is very simple and only uses the NYSE Advance Decline line and the SP500 closing price. This models esge is not huge but it is solid and historically you are risking about 1:1 meaning that the historical return is almost the same as the worst historical drawdown.

In our newsletter and in our own trading we rarely use a model as an automatic buy or sell signal but we do use them to tell us which dorection to trade. Right now this extremely simple model is showing that the advance delcine line has finally been able to have a sustained run and break above its long term trend, in this case the 150-day moving average. Again we don’t, and don’t recommend, trading directly off of these signals as almost every model we track can be improved upon by selecting better entry and exit points but they do helo us tremendously in our trading.

SP500-NYSE Advance Decline Line

sp500-advance-decline-model-4

As you can guess we are becoming increasingly bullish after being bearish for the better part of two years. Who knows if this rally will continue as there are a ton, and maybe a trillion tons, of harsh economic realities and hardships, but for now the trend is up and we are starting to lean to the long side.

Happy Trading,

Dave@TheMacroTrader.com

P.S. If you are getting value out of our posts, you can do us a favor by linking to us with your site or blog and mentioning The Macro Trader to any of your friends that trade.