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The summer months are a time for taking a break, basking in the sunshine with friends and family, and financial markets going loopy for little or no obvious reason.
As we approach the season in the northern hemisphere and markets start their usual process of thinning out and flapping around, there’s every danger of some kind of flare-up in the coming months.
An amuse bouche for that came last week with some peculiar movements in the Japanese yen. Generally speaking, the yen is one of the currencies, along with the dollar and the Swiss franc, that performs pretty well in times of stress. It’s not a haven as such, but the folklore in markets is that during turbulent or scary periods, Japanese investors bring home their funds parked in overseas assets, pulling up the yen in tow.
Whether those repatriation flows ever truly happen at scale is a matter for debate. They probably don’t. But muscle memory in markets is a powerful force, so when bad stuff happens, of any flavour but particularly in geopolitics, the yen pushes higher.
Not so with the latest intensification of violence between Iran and Israel, with US involvement too. Instead of shooting higher, the yen weakened. Not dramatically, but the dollar rose to a high of ¥148 by the start of this week, marking the yen’s weakest point in a month.
A one-month low in the yen may not sound like a big deal, and for most people, it was not. The problem here sets in because betting on a weaker dollar, and a stronger yen, is hugely popular among hedge funds and other speculative investors. When that bet started to unravel, we saw what Dominic Bunning, an analyst at Nomura, describes as a “nasty squeeze”. He came close to folding on his own recommendation to clients to buy the Japanese currency — never a pleasant moment for a peddler of ideas at an investment bank.
Crucially, the episode suggests that the bet against the buck is getting a little crowded, and you don’t need a long memory to recall how crowded bets can sour at speed. Just last summer, the yen shot higher and at the same time, US tech stocks shot lower as two highly correlated and highly popular positions at heavy-hitting hedge funds hit a wall and quickly reversed. Markets became so messy (or so I’m told — I had the good sense to sit this bit out on a sunlounger in Turkey) that at one point the debt markets were pricing in an emergency interest rate cut from the US Federal Reserve.
An emergency cut never happened, of course. But markets are particularly prone to overshooting when summer holiday season pulls people away from their desks and gaps start to open up where firm tradeable market prices would usually be.
It is well worth, then, keeping a close eye on areas of widespread consensus in financial markets, in case they suffer similar summer flings. The yen is one such area. If the US is unwilling or unable to cut interest rates, either because of sticky inflation or because the economy performs better than feared in the opening months of this year, the ascent in the yen that hedgies hope for may not materialise. Investment banks and central banks alike are growing less gloomy on the US outlook and this is an upside risk to take seriously.
Chris Scicluna, an analyst at Daiwa Capital Markets, thinks a continued orderly decline in the dollar is still the most likely outcome from here, and that a summer shake-out in its exchange rate with the yen remains unlikely, although this forecast may be, as he noted, his “famous last words”.
Shocks are, by definition, impossible to predict. But Scicluna sensibly points out that a better place to watch might be other pockets of markets that have had a great run so far this year and that might be pushing their luck and getting a little overcrowded.
Some European currencies, for example, like the Swiss franc and the Swedish krona, have had a spectacular run. European stocks have carved out an impressive and uncharacteristic ascent. Even those, like me, who believe in a long-term rotation out of the US and into Europe, can admit that a 18 per cent climb in German stocks just this year is perhaps a little excessive.
Meanwhile, US stocks are plodding in Europe’s wake. If President Donald Trump keeps on chickening out of tough economic decisions, maybe they can catch up and the dollar can catch a break. Sentiment here is possibly overly gloomy.
Mini-reversals in the summer tend to fade as fast as a tan but you can get burnt in the process. A little summertime caution goes a long way.
katie.martin@ft.com
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