Global markets head south

The equity market correction is by far not yet complete, indicated by the widening spread between cash and equity market future indices, implying that investors did not get quickly enough out of equity holdings, according to an analysis by BNP Paribas.

Substantial financial market leverage makes things worse with the rising yen adding concern of ‘carry trade’ liquidation. So far, the rising yen has been caused by Japanese accounts reducing foreign currency risk ahead of the fiscal year end, indicated by weekly MOF security flow data showing Japanese accounts reducing (currency unhedged) foreign bond exposure.

In addition, the Nikkei lost 3.3%, now trading 4% below early January levels, reducing the portfolio value of foreign accounts in Japan. Foreign accounts hold Yen denominated shares on a currency hedged basis, suggesting that the reduced ‘value at risk’ causes addition yen buying as hedging ratios are adjusted.

Meanwhile, the CME has increased the margin requirement for yen trading by 25%, supporting our view that rising volatility will weaken liquidity.

The US yield curve has undergone a dramatic steepening as investors shift funds from equities into near cash assets. Next to this ‘technical’ factor BNP Paribas analysts see fundamental reasons for a steeper US yield curve. The US subprime mortgage crisis is unlikely to remain an isolated event given that the subprime market represented 25% of the entire mortgage market in 2006. Tighter credit standards have made sub prime new mortgage business collapse, while repossessions will add supply to markets already seeing house prices fall.

 

USDJPY

Positive Japanese data add to carry trade unwinding, similar to the 1998 situation.

USD/JPY made a strong break through key trendline support at 116.80 Monday morning. GBP/JPY was the biggest mover earlier in the day after HSBC Holdings PLC announced a USD10.6 bln write-off on its US sub-prime mortgage business.

Moreover, Asian equity markets have remained under pressure with the Nikkei down more than 3% and the VIX index rebounding after trying to decline in the middle of last week. As long as risk aversion and volatility remain in the market, BNP Paribas analysts expect USD/JPY to keep its downside bias in place. In Japan, capital spending data

surprised on the upside with Q4 capex surging 16.8% y/y from 12.0% in Q3. Markets were expecting a 13.7% reading. The breakdown reported a recovery in manufacturing capex which accelerated to 15.4% from 7.3% in Q3. Nonmanufacturing capex remained very robust at 17.5%. The data suggest that Q4 GDP will be revised higher on March

12. But the important thing to note is that as in 1998 when carry trades were being unwound, positive Japanese data added to the pressure for carry trades to come under pressure.