The major market indexes may be set to rebound for a week or so. Why? Because the carry trade is oversold. The carry trade is a mechanism large banks use to earn interest on sitting money. It is conducted between the Australian Dollar (which still pays the highest interest of a major currency) and the Japanese Yen (which charges virtually nothing). Large money holders make money by parking their funds in this trade as it collects interest on a daily basis.
When money goes into this trade (and the Australian Dollar rises in value compared to the Japanese Yen), it means that investors prefer to be taking on risk. But when investors feel like they need to reduce exposure to risk, they come out of this trade, weakening the Australian Dollar and strengthening the Japanese Yen.
This trade correlates very closely with the US market indexes. When they two diverge, it is bearish for US markets. But right now, there is very little divergence. Instead the carry trade is showing that it has closed lower more than 80% of the sessions in the last month, designating it as oversold. This can be seen using almost any time period of Stochastic indicators. Consider this graphic showing the action on three different settings of the Stochastic indicator (see figure).
Buying already? But we just got done selling!
This figure shows that the amount of selling done on the carry trade has put it in position for a short-term rebound. That might not sound like such a big deal, but don’t forget the correlation between this currency pair and the US market indexes. If investors want to put their money at risk, then money will find its way into the stock market. If they don’t, market prices will fall until they do.
Since the carry trade has been falling for a while and has now recently paused in its decent, it’s action has set the stage for a rebound. If the carry trade rebounds, then US markets are likely to begin rising, even if briefly. In fact, the last few times that the carry trade rebounded from this position, the S&P rose three percent or more in the two weeks that followed.
But we don’t just have to look at the carry trade for predictive capability. We can find another good indicator that the major market indexes are not likely to plunge right now. Market indexes should continue to be at least a little buoyant based on the way they have reacted to the news that J.P. Morgan (JPM) lost money trading. Friday’s action may have some selling, but nothing like what it could have been if the market thought this meant a threat to the solvency of the banking system.
Market Chaos or Modern Competition?
Banks losing billions? Oh the horrors! Some pundits may try to claim this is a signal of market disorder, and that greater controls are needed. Poppycock. Anyone writing that would reveal their displaced political bias and lack of experience with how the markets operate. J.P. Morgan became the second major banking operation to realize trading isn’t so easy as it used to be. Last quarter it was Goldman Sachs who had to admit their trading division wasn’t the cash cow it once was.
Given the technological advances in the markets and the increased number of participants using that technology, a better explanation for these losses is the fact that these trading desks bled talent and simply lack the ability to compete effectively. It isn’t a systemic catastrophe. It’s a call for banks to stop trying to be traders, or pony-up the resources to figure out how to do it better.
Meanwhile, since the markets didn’t act like the news was the second coming of the Lehman failure, it is likely safe to assume that buyers are getting ready to shop around in the coming days ahead.