Andy Krieger's Thoughts on the Market - 13 July 2023

In my last write-up, on June 12, 2023, I cautioned my readers not to be fooled by the yen weakness that was dominating the foreign exchange market as the dollar would not be able to sustain a move above 143.00 yen per dollar. I was sure the yen weakness would prove to be fleeting, and I noted that once the dollar’s down move starts in earnest, we need to “look out below.”

Well, the reversal in dollar yen from the recent highs (it just touched 145.00) has been fierce. And now, it's time to look out below as it looks like it might carry on.

On July 5, the dollar was trading just below 145.00 yen per dollar. In the last six trading days, it has plummeted to 138.00, wiping out over two months of hard-fought dollar gains. Is this the start of the mega move that I have forecasted? It is still very early in the move, and there will be periodic violent corrections, but the recent action feels like it is the start of something very big.

My original target was for the dollar to crash off to sub-120 levels. I still think that is possible. We should watch this pair closely, because it will almost certainly present fabulous trading opportunities over the coming weeks and months.

The market has been plowing into short yen carry plays of massive size for many weeks. The yen carry play is when investors sell yen and buy higher yielding currencies (such as US dollars) to earn the interest rate differential between interest rates in the U.S. and Japan. The annual differential is about four and a half percent (4 ½%), and that differential may seem very attractive -- until a full year of anticipated earned interest is more than wiped out in a week!

Carry plays work well when the yen is stable or depreciating slowly. This strategy, however, is a disaster when the yen surges quickly, as the benefits of the interest rate differential evaporate, leaving investors with huge losses from their currency exchange rate exposure. The unwinding of these carry plays has only started, as there hasn’t been nearly enough time for most investors to bail on their positions.

Typically, the investors who put on carry plays are institutional investors who react slowly and methodically to market movements. Once the unwinding starts, however, it tends to accelerate, with the dollar crashing off as stop-loss orders get progressively triggered. This is the perfect example of the proverbial up the stairs and down the elevator market action.

These sorts of rapid market conditions present many great trading opportunities, particularly with currency options. Yen options had become very cheap recently as volatility in yen pairs had become quite suppressed. With the recent surge in the yen, volatility spiked sharply, jumping up by over 50%. A move in volatility of this magnitude will more than double the value of an at-the-money option with a three-month maturity.

If someone had purchased a low delta yen call (for example, struck at 137.00), then the combination of the recent move in spot combined with the jump in volatility would have yielded a tidy return of nearly 400%. These are the sorts of plays that I just love – when volatility has become suppressed, and the market is ripe for a big move.

Historically, markets have been terrible predictors of future levels of volatility. That is because volatility is backwards looking, so it is pricing in past data as a theoretical predictor of future levels of volatility. For many reasons, this is a fool’s game, as markets typically consolidate, and market action gets compressed right before very sharp market moves. It is one of the main reasons that I have always used options to capture large, anticipated moves. The risk reward is overwhelmingly attractive when options are used in a clever way.

I also noted in my last write-up that the 1.43 Canadian dollar per euro rate was the end of the cross-pair’s correction, and that the euro was set to start strengthening against the Canadian dollar again. It has now rallied up above 1.4700, and it looks like it might have a lot more room to rise over the coming weeks. It won’t be a straight-line rally without some sharp corrections, but the uptrend seems to have reasserted itself.

Overall, the dollar is under heavy selling pressure. It is weakening against most major currencies, not just the yen. The Swiss franc has just touched levels not seen for over eight years, and the British pound and Euro are touching levels not seen for over a year. The U.S. economy is holding up surprisingly well and inflation appears to be dropping at a rapid rate, so why is the dollar under pressure?

The market right now is focused on relative interest rates, and it seems likely that UK and European rates have more room to climb, while U.S. rates are near a plateau. Inflation appears to be moderating, so future rate hikes are less likely here in the U.S. Frankly, it is kind of silly, but the forex markets like to latch onto a theme, however misguided the thinking might be. I have seen cycles when the market was preoccupied with trade deficits. At other times, it was focused on relative growth rates. The point is that forex is a fickle market which can shift its tune quite quickly, for no apparent reason. That is both part of the fun as well as part of the challenge.

The underlying fundamentals remain unchanged. Speculators are buying stocks with wild abandon, and the rising market keeps sucking in more and more buying from players who are afraid of missing out. In this sort of environment, it is fine to ride the speculative frenzy, but one should keep very tight trailing stop-loss orders in place to protect profits before the eventual sharp sell-off that will follow.

Regarding the AI influence on the market overall, I think that is has probably delayed the bursting of the stock market bubble by several quarters, but a sharp market sell-off is still a high probability. The tech bubble in 2000 coincided with a modest recession, but the Nasdaq still managed to drop by 82%. So far, we have managed to avoid a recession despite a 500-basis point hike in interest rates, but we are far from out of the woods. We could easily slide into a mild recession by the end of the year, but that doesn’t mean the stock market’s eventual sell-off won’t be large.

Very bright analysts are sharply divided over whether we will experience a sustained doubling of productivity over the coming years from the AI boom, or not much of a sustained improvement at all. Either way, I see some serious societal risks depending on how AI is used. That is a separate issue from whether we should be taking some profits off the table if we were long some of the Big Tech stocks this year. My bias is to grab some profits and keep the stops very tight on the remaining positions.

Overall, many significant risk factors remain, and we should not ignore them. Some of them are more obvious, such as the possibility of increased geopolitical tension and the risk of potential future military conflicts in key regions. Aging populations are another risk that we need to consider, as this could lead to reduced workforces and the demand for higher wages. We also could face more intense and more common natural disasters due to environmental changes. This could have adverse effects on various supply chains, leading to higher prices and renewed inflationary pressures.

As you can see, the initial risks that I am keeping a close eye on are all potentially inflationary. We are seeing improvement in the CPI and PPI data, but we should not be too sanguine about the future. Inflation has a way of roaring back quickly and biting us badly when we get too complacent. Regardless of how these factors play out, we are set for increased volatility in many markets and some fantastic trading opportunities.

Best of luck,

Andy Krieger

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