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Risk Aversion Not Just an Equities Story: Look for the Yen to Weaken

May 12th, 2010 Michael McDonough

The AUD/JPY exchange rate, commonly used as a carry trade to take advantage of stark interest rate differentials between the two countries, is also a measure of investor risk.  For that reason it may surprise some of you to learn the cost of the Australian Dollar in terms of the Japanese Yen is tightly correlated with the S&P500’s performance.  Both trades invovle risk, and as investors appetite for risk diminishes so to does demand for equities, while demand investors rush into the Yen to quickly unwind their potentially highly levered carry trades.

Risk aversion has also kept the USD/JPY trading relatively range bound, but improving U.S. fundamentals coupled with Japan’s fiscal weakness could be setting the cross-rate up for a bounce.  I expect that recovering investor sentiment, which will eventually lead to a decline in U.S. government bond purchases, will also coincide with a sharp depreication for the Yen in terms of U.S. Dollars.  The chart below highlights how the relationship between the AUDJPY cross-rate against the USD/JPY rate has broken down since the start of 2009.  I expect that USD/JPY rate will gradually increase to 100 from the current level of 93.25 as confidence returns to the market, and investors begin to digest the extent of Japan’s fiscal weakness.  In fact, with the preface that Japan is no Greece, the country’s finance minister recently announced they wanted to extend the average maturity of Japan’s government debt to reduce its refunding risk.  Japan’s debt to GDP ratio is expcted to hit 227% of GDP this year; Greece 110%… 

AUD/JPY, USD/JPY, & the S&P 500

Source: Bloomberg
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