May 23, 2013, 1:18 p.m. EDT
By William L. Watts, MarketWatch
NEW YORK (MarketWatch) — Japan’s stock market plunge, a sharp rebound by the yen, and even the temporary whack taken by major U.S. indexes on Thursday all help demonstrate what happens when trades get too crowded.
“Whenever one market becomes very crowded, that’s usually when the music ends,” said Adam Sarhan, chief executive at Sarhan Capital.
Since last fall, traders have been playing dollar/yen (ICAPC:USDJPY) as though it were effectively a one-way bet. The dollar earlier this week pushed above ¥103 for the first time since October 2008, and even with Thursday’s 1.6% decline remains up more than 17% versus the yen year-to-date.
Japan’s benchmark Nikkei 225 Index (TYO:JP:NIK) rose more than 70% from its 2012 lows and remains up nearly 67% since November even after Thursday’s drop.
It all comes down to quantitative easing. The yen plunge and Nikkei rally took on the qualities of a force of nature as Shinzo Abe led his party to victory in parliamentary elections last fall, pledging to force the Bank of Japan to aggressively fight deflation and promising fiscal action as well.
In April, the Bank of Japan announced a massive ramping up of its quantitative-easing program, accelerating the yen’s decline. Japanese stocks rallied, in turn, partly on expectations a weaker yen would aid exporters.
The aggressive Bank of Japan moves also fed into the notion of a global hunt for yield, with traders jumping into an array of so-called risky assets on expectations Japan’s efforts would force the nation’s investors to look outside Japan for returns.
But the catalyst for Thursday’s drop came from Federal Reserve Chairman Ben Bernanke, who a day earlier had surprised investors by indicating the central bank could conceivably move to start paring back its own asset-buying program in coming months if the economy begins to improve.
The tone was only reinforced after minutes from the Fed’s latest meeting showed some policy makers were open to tapering the bank’s asset-buying program as early as June.
That knocked U.S. markets down Wednesday and set the plate for Thursday’s Nikkei rout and yen carnage, along with a rise in Japanese government bond yields. Throw in weak Chinese data and the stage was set for trouble in Tokyo.
Adam Cole, head of G-10 FX strategy at RBC Capital Markets in London, said it was “capitulation in to seriously crowded trades” that dominated price action.
He zeroed in on the latest round of weekly flows data from Japan’s Ministry of Finance, which showed that early signs of Japanese investors returning to foreign bond markets had been unwound.
Instead, the data showed investors had unloaded ¥804 billion ($7.910 billion) of foreign bonds in the week to last Friday, Cole noted, more than unwinding purchases over the previous three weeks of around ¥700 billion.
At the same time, foreign investors had plowed around ¥700 billion into Japanese equities and ¥450 billion into Japanese money markets in the latest week, for an overall net capital flow of ¥2.2 trillion into Japan.
“Once again, the rally in dollar/yen (around 2 full yen over the period covered) seems to have been driven by speculative flows, not underlying assets flows. The absence of ‘real’ flow behind moves in dollar/yen makes it difficult to judge how far the correction lower can run, though strong technical support comes in at ¥99.90,” Cole said.
For equity markets, central banks will likely continue to call the tune, strategists said.
It’s possible that markets could end up in an environment where ostensibly positive news on the economy undercuts equities if it heightens fears the Fed will move to cut back on its stimulus efforts, Sarhan said. On the other hand, data that show investors that the economy can grow without QE would reassure investors, though the evidence would likely need to be overwhelming to convince market participants, he said.