Monday's Unusual Market Action
On Monday we saw stocks and US treasuries go down. We also saw gold decline. This - most especially stocks and US treasuries - is unusual action, but not unique. We've seen it several times in the last couple of weeks.
Normally, if stocks aren't favored, investors turn from those more "risky" assets to the relative safety of treasuries. The typical action in stock downdrafts sees treasuries, therefore, rise.
As for gold, it correlates at time to stocks, negatively or positively. Same for its correlation with treasuries. More frequently, it responds negatively to a strong US dollar. And yesterday the dollar strengthened. Based on that, we can consider gold less of a puzzlement.
But the puzzlement remains for stocks and treasuries. Are we witnessing some sort of historic realignment of the typically negative correlation betwixt the twain? Unlikely. Our research indicates that we may rather be witnessing the effects of "unwinding" of leveraged trades, especially those involved in the long-running so-called "carry trade." Without getting into specifics of how this trade has enriched leveraged traders for many years now, all we need do is focus on the term "leverage."
When a trade is "leveraged," we simply mean that one has borrowed money to purchase something. For example, when one has a margin account, one might buy stocks on margin, margin representing an amount loaned by your brokerage firm to you so that you can buy some stock or stocks with money you don't currently have available.
This can be quite lucrative for those professional traders who know what they're doing; it's typically a bad idea for the rest of us investors. The reason it's bad is that, while we might be good at the fundamental analysis required to identify an under-valued security, few of us can predict the direction of the market. And even if our undervalued security screams "Buy!" at us, if the general market decides to turn down for one or more of a variety of reasons, our undervalued stock may well follow the herd, leaving us with what's called a "margin call." That's when the value of our stock has declined to such a degree that our broker - the party that loaned us money via margin, comes to us and demands more money to increase the margin in our account. Since we typically need to keep our margin at 50% (more or less, depending on your account), if that value decreased because the value of your stock decreased, the broker wants more money.
Investors can do quite well without resorting to this sort of use of margin.
Traders, on the other hand, thrive on it. And in the case of the "carry trade," they are likely borrowing Japanese Yen, whose trend has been down, and whose relative value is low relative to US Dollars, in order to purchase US dollars, whose trend has been up, and whose relative value to the Yen has been high. Of course, just buying US dollars won't make any money, unless you sit and wait for the value of the dollar to continue to climb. So instead, these traders take their dollars and purchase US treasuries, which will pay them a guaranteed rate of return, and promise to return their capital as well.
But even that won't satisfy them.
Rather than, let's say, borrowing yen at 0.2% (and paying that interest, plus some slim profit margin to their broker who loaned them the yen), and buying treasuries - for example, the 10-year which pays, let's say, 2.20% - thereby earning roughly 2% on a virtually guaranteed basis, they prefer using leverage to increase their return. And so they borrow even more from their broker so they can increase their return. Some borrow 100 times their capital, some as much as 300 times. (These would typically be hedge funds.)
The problem arises when either the dollar weakens in price or the yen increases in price. This causes their brokers to call for more money to square away their margin requirements. And, lo and behold, such has been the fate of the dollar and the yen recently, with one or sometimes both pushing in the exact direction that leaves these traders gasping for air, more accurately grasping for cash. And in the case where they need cash to bolster their margin requirements, the easiest thing to do is sell US treasuries, one of the most liquid securities in the world, with the lowest bid-ask spreads.
And that's what may be happening now as stock decline seemingly without engendering a rush into the safety of treasuries. The bump in price that treasuries might have received from those seeking safety is offset by the decline in price caused by those leveraged players selling those same treasuries to protect themselves.
Well, that's a far more technical analysis and explanation than we typically engage in here. It may be a bit confusing, as it sometimes is to us as well. But at least it does attempt to address the puzzlement of stocks and treasuries lately going down in tandem.
For more on the general concept of "puzzlement," please watch the following.
As for the confusion caused by such a puzzlement, and in recognition of the yen's role in the puzzlement, here's the same song, but this time in Japanese.
Normally, if stocks aren't favored, investors turn from those more "risky" assets to the relative safety of treasuries. The typical action in stock downdrafts sees treasuries, therefore, rise.
As for gold, it correlates at time to stocks, negatively or positively. Same for its correlation with treasuries. More frequently, it responds negatively to a strong US dollar. And yesterday the dollar strengthened. Based on that, we can consider gold less of a puzzlement.
But the puzzlement remains for stocks and treasuries. Are we witnessing some sort of historic realignment of the typically negative correlation betwixt the twain? Unlikely. Our research indicates that we may rather be witnessing the effects of "unwinding" of leveraged trades, especially those involved in the long-running so-called "carry trade." Without getting into specifics of how this trade has enriched leveraged traders for many years now, all we need do is focus on the term "leverage."
When a trade is "leveraged," we simply mean that one has borrowed money to purchase something. For example, when one has a margin account, one might buy stocks on margin, margin representing an amount loaned by your brokerage firm to you so that you can buy some stock or stocks with money you don't currently have available.
This can be quite lucrative for those professional traders who know what they're doing; it's typically a bad idea for the rest of us investors. The reason it's bad is that, while we might be good at the fundamental analysis required to identify an under-valued security, few of us can predict the direction of the market. And even if our undervalued security screams "Buy!" at us, if the general market decides to turn down for one or more of a variety of reasons, our undervalued stock may well follow the herd, leaving us with what's called a "margin call." That's when the value of our stock has declined to such a degree that our broker - the party that loaned us money via margin, comes to us and demands more money to increase the margin in our account. Since we typically need to keep our margin at 50% (more or less, depending on your account), if that value decreased because the value of your stock decreased, the broker wants more money.
Investors can do quite well without resorting to this sort of use of margin.
Traders, on the other hand, thrive on it. And in the case of the "carry trade," they are likely borrowing Japanese Yen, whose trend has been down, and whose relative value is low relative to US Dollars, in order to purchase US dollars, whose trend has been up, and whose relative value to the Yen has been high. Of course, just buying US dollars won't make any money, unless you sit and wait for the value of the dollar to continue to climb. So instead, these traders take their dollars and purchase US treasuries, which will pay them a guaranteed rate of return, and promise to return their capital as well.
But even that won't satisfy them.
Rather than, let's say, borrowing yen at 0.2% (and paying that interest, plus some slim profit margin to their broker who loaned them the yen), and buying treasuries - for example, the 10-year which pays, let's say, 2.20% - thereby earning roughly 2% on a virtually guaranteed basis, they prefer using leverage to increase their return. And so they borrow even more from their broker so they can increase their return. Some borrow 100 times their capital, some as much as 300 times. (These would typically be hedge funds.)
The problem arises when either the dollar weakens in price or the yen increases in price. This causes their brokers to call for more money to square away their margin requirements. And, lo and behold, such has been the fate of the dollar and the yen recently, with one or sometimes both pushing in the exact direction that leaves these traders gasping for air, more accurately grasping for cash. And in the case where they need cash to bolster their margin requirements, the easiest thing to do is sell US treasuries, one of the most liquid securities in the world, with the lowest bid-ask spreads.
And that's what may be happening now as stock decline seemingly without engendering a rush into the safety of treasuries. The bump in price that treasuries might have received from those seeking safety is offset by the decline in price caused by those leveraged players selling those same treasuries to protect themselves.
Well, that's a far more technical analysis and explanation than we typically engage in here. It may be a bit confusing, as it sometimes is to us as well. But at least it does attempt to address the puzzlement of stocks and treasuries lately going down in tandem.
For more on the general concept of "puzzlement," please watch the following.
As for the confusion caused by such a puzzlement, and in recognition of the yen's role in the puzzlement, here's the same song, but this time in Japanese.
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