Irrational Market Behavior and Overblown Reactions

I have been writing for a few weeks about the market’s abysmal reaction to the Fed’s dramatic rate cut in September.  Not only did that ill-timed move by the Fed mark an important low in interest rates, it also marked a low in dollar yen (usd/jpy).  As you can see from the chart below, the recent correlation between usd/jpy and the 10-year yield in US interest rates has been astonishingly high.  The formula is simple – US 10-year rates go up and usd/jpy goes up.  US 10-year rates go down, and dollar yen goes down.  The correlation is not perfect, but it is extraordinarily high.  The recent eighteen percent rally in 10-year yields has triggered an explosive, parallel move higher in usd/jpy of roughly ten percent. 

These are not “normal” moves in either the currencies or the rate markets, as moves of this magnitude usually take MUCH longer to play out.  Put simply, the volatility that the Fed’s interest rate cut has triggered has been extreme, albeit somewhat counter-intuitive.