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.

As you can see from the charts below, this extraordinarily high correlation has been in force for some years, and the recent trade higher in usd/jpy was in certain ways highly predictable given the long-term correlation between the 10-year interest rates and dollar/jpy.  In fact, the shape of each chart is astonishingly similar.

Going forward, I am not necessarily expecting this correlation to hold.  It is overly simplistic to simply suggest that the shift in the direction of 10-year yield In the US is a perfect predictor of usd/jpy.  I wish it were so easy.  In fact, there are many reasons why the 10-year yield may rise or fall at different times, and sometimes these reasons may lead to the opposite move in the usd/jpy. Moreover, there are many times when a large move in usd/jpy occurs without the 10-year Treasury yield shifting much at all. 

The best way to think of currency shifts is to remember that they are thematic.  In the current environment, traders have a sort of fascination with, or even a sort of addiction to the concept of yield.  I have written extensively about the carry trade, and in typical fashion, traders have latched onto this theme and driven the yen up and down against the dollar and other currencies to unsustainable levels.  This sort of irrational behavior is consistent with speculative activity for hundreds of years, so it is hardly unsurprising.  Rather, it is just a reminder that in currency trading – and other markets – we need to pay close attention to the themes that are driving the speculative fervor at the time.

I remember, for example, when the monthly trade figures were the dominant driving force in the currency markets.  Unexpectedly large deficits with Japan yielded outsized sell-offs in the dollar, and conversely, a surprisingly  narrow deficit led to aggressive short covering and a sharp rise in the dollar.  The impact of the yield differentials, or the trade deficits, or any other dominant theme, tends to lead to dramatically overblown market reactions.  Speculators love to jump on trends and this in turn creates momentum which further fuels the moves way beyond sensible levels.  The risk in gauging when it is time to bet against a market’s irrational behavior is that the stupidity of the herd mentality sometimes exceeds all reasonable analysis.  It is for this reason that I like to use limited-risk option strategies when I trade.  I know that I will often be early, so this allows me to hold onto my bets while the market finishes its idiotic overextensions.

If you read back through my write-ups, you will note that I got progressively more committed to the idea of a massive reversal in the yen carry play in the late spring and early summer.  I wasn’t sure when the yen would stage a powerful reversal, but I was absolutely sure that the move was going to be vicious.  I was also sure that the first stop in the overall reversal would be around the 140.00 yen per dollar level.  

There were many reasons I was so committed to this idea, and just as I was advising my readers to structure long yen bets through the month of June, I was also advising my readers to take profits on their yen position when we reached the 140 level in mid-September.

Going forward, I am now comfortable with the idea that it is time to reload on bullish yen bets.  The dollar’s recovery this week to the 153.20 level seemed absurd, and I was very happy to have the chance to reload on some of my long yen bets at these levels.  Is the dollar going to start crashing lower towards the 127.00 level from here?  It is way to early to say, but it is certainly time for a breather; and at a minimum we should have a sizable move to correct the nearly 14-yen bounce in the dollar over the past five weeks.  

As you will rightly conclude, I am also expecting a correction in the 10-year Treasury yield.  The market absolutely got way ahead of itself in reaction to the Fed’s jumbo rate cut, but an 18% rise in yields in five weeks just seems to be overdone in the short term.  I will note, however, that I am more convinced about the yen’s recent weakness being overdone than the current move in treasuries being overdone.  

The volatility of the market’s expectations about the Fed’s future rate cuts seem absurd to me.  Bond traders started to price in silly amounts of Fed easing at the first sign of economic softening, which I feel is in many ways is a reflection of the long-term strategy of the Fed to lower rates at every opportunity  for the past forty years.  The world, however, has changed.  

I believe that the neutral rate for the Federal Reserve is now much higher than it was over the past ten or twenty years.  Stronger inflationary pressures are built into the system, and there are many reasons for this.  The amount of money that the Fed has pumped into the system is one reason.  The amount of money that our government has borrowed and spent is another.  Thirty-five trillion dollars of debt is a massive number, and the funding of this debt is going to require ever greater amounts of interest payments every year given the bipartisan attitude of Congress to keep the spigots wide open to support economic growth.  Neither party wants to see a sharp economic downturn, and this means that there is a powerful disincentive for Washington to seriously raise taxes, reduce our deficit, and get our fiscal house in order.  The logical conclusion of Washington’s policies is clear – inflation, over time, is here to stay in one form or another.

Remember, the Fed’s 2% inflation target is something of a joke.  It sounds nice, but the reality has been very different.  It is a tax on every one of us, and as you will shortly see, the Fed hasn’t even come close to achieving its goal.

The demand for treasuries is not infinite, and the dollar’s hegemony is being aggressively challenged right now.  Will the dollar’s supremacy be toppled in the near future?  That is extremely unlikely.  Will it suffer a series of nicks and bruises over time?  Absolutely.  This is already happening with the invoicing of some oil deals and other commodities in other currencies, but the US likes its dominant position, and it will go to extreme measures to defend it.  Higher interest rates will likely be one of the requirements over time in order to attract sufficient investors to buy our debt.  The tipping point will be the point at which investors grow seriously worried about the ability of the US to remain solvent and cover its ever-growing financial obligations.  

Yes, this is an oversimplification of the huge debate between Keynesian economics and the Monetarists, but the fact is that money ultimately gets applied to the purchase of goods and services – and our government (and the Fed’s willingness to keep financial conditions loose) is hell-bent on spending lots of it.  Without going into the weeds to argue about some of the nuances, the bottom line is that inflation is almost certainly going to be the by-product of this long-term process.  That will play out in the classic process of the dollar’s buying power simply diminishing over time.  Depending on global conditions, that could lead to a sharp dollar decline or rise, but the certainty is that a dollar will buy fewer goods and services domestically.

We already see this in the cumulative costs of living in the US.  The average cost of a home in America in 1985 was roughly $100,000.  Today the average home costs $500,000.  This is enormously more than the theoretical cost of $293,000 that the government’s official CPI rate would suggest we should have today.  In education, the situation is even worse In 1985, the average cost of tuition and fees at Ivy League schools was around $9,500.  Adjusted for our official government inflation rates that would be approximately $27,890 in today’s dollars.  The reality, however, is quite different.  For the 2024 academic year, the average cost of tuition and fees at Ivy League schools is about $65,000 per year.  For college costs – not including the massive increase in associated costs of housing, books, associated travel, and incidentals – the annual rate of increase has been over 5.5% versus the government’s theoretical – but official -- 2.8%.  Even their official rate far exceeds their 2% target, and the authorities NEVER want to discuss what the cumulative impact of this inflation means to the average person.

I could give many more examples, but the reality is disturbing.  The true cost of inflation has been much worse than the government would have us believe.  Moreover, even accepting the understated data from the government, you will notice that inflation started accelerating on its upward trajectory when the US decided to abandon the imposed discipline of having a gold-backed currency in favor of the current fiat currency regime in the early 1970’s.

Wages have clearly not kept up with the true cost of inflation.  It is only in this area that the official government rate inflation rate has been a fairly accurate measure.  Put differently, wages have increased at roughly the official rate of 2.8% of annual inflation, while other real costs have increased much, much faster.  People are much poorer now in real terms than they were 39 years ago.  My decision to use 1985 as a benchmark was arbitrary, but we would find the same results whenever we started.

The stock market is clearly not a sensible measure of how the country is doing economically.  Sure, it reflects how the wealthy people are faring, but it is a terrible gauge on a broader scale.  The extent to which the Fed – and the federal government – focus on the performance of the stock market provides a great insight into whose interests the government is really serving.  We shouldn’t deceive ourselves and believe that either political party has really been serving the people of our country.  The focus has been quite selective.

Over time, the correlation between the dollar yen and US 10-year Treasury yield will surely weaken, and at some point, it will likely reverse.  It is the point at which the correlation reverses when we should be frightened because it will signify that the US rates are climbing because money is fleeing.  This can happen over shorter periods of time when there are periods of fear and panic, but the correlations typically revert back after a while. My concern is that when we reach the tipping point, the correlations won’t revert so quickly. 

As an example, consider the Great Recession.  When it hit us in 2008, dollar yen crashed lower out of fear.  The Fed lowered rates dramatically and pumped trillions of dollars into the system to try to save the financial system, but the dollar’s decline did not follow the Treasury 10-year yield.  Rather, the dollar’s decline led the decline in rates.  

I want to point out an interesting correlation that also seems to be driving quite a large amount of speculation in the markets today.  Consider the following chart in which I have overlaid the election betting results of Polymarket versus the US 10-year Treasury yield.  The correlation with the prospects of Trump with the rise, the fall, and the subsequent rise in yields is shockingly high.  Clearly, the speculative market views a possible Trump victory as inflationary, while it views a possible Harris victory as being disinflationary.  

I could write for many pages about the assumptions the market is making, but suffice it to say that the market has already taken some very heavy bets on the outcome of the election. The extent to which the ultimate winner can implement his or her intended policies is a very big question.  There are many reasons that the ultimate policy implementation of a new President often deviates substantially from the promises made on the campaign trail, but the reality of Washington politics typically dictates substantially watered down policy shifts.  The makeup of Congress will clearly play a big role in the ultimate policies we see from the new President, and that is about as uncertain as the selection of our next President.

I will go so far as to note that in fact, the intended policies of Trump would be quite inflationary.  Heavy tariffs on imported goods would definitely lead to some price increases.  Likewise, some of the aggressive social plans of Harris would likewise lead to upward price pressure.  However I look at this election, I see a reasonable chance that inflation will rise, but the underlying causes would differ.  The impact on the markets would likewise differ, with potentially very different impacts on US Treasuries and the stock market.

In fact, I think the biggest short-term impact of the election could potentially be the possible uncertainty that might follow on the heels of a very close outcome.  I could easily envision all sorts of chaotic conditions as both parties fight and scrap over the results, which might not even be finalized for some days – or weeks after the election.  I think it is a bit naïve to assume that everything will flow smoothly with this election given the bitter divisions between the Democrats and Republicans right now.  I think we need to be realistic about a possible spike in volatility in the markets over the coming weeks and strap on our seatbelts for a possibly wild ride.

We will certainly be revisiting the topic of the election over the coming weeks but let me leave you with a quick reminder about my long-term bullishness in gold and silver.  My readers are certainly familiar with this view since I have been writing about buying gold  since it was trading at $1620 per ounce.  I started to write about buying silver when it was preparing to break higher from the $22 per ounce level.  This week we saw gold post a new all-time high at $27.58 and silver posted a new multi-year high at $34.86.  As I wrote recently, I still expect a period of consolidation in the precious metals before they continue their multi-year climbs higher.  Still, as I recommended recently, I like the idea of taking profits on a portion of our long position and waiting for the markets to adjust back to a more balanced technical position before reestablishing our full exposures.  Remember, markets can correct through price or time.  I am expecting this corrective period to be one of sideways consolidation rather than sharp price corrections.  For long-term investors, there is no need to make any adjustments as eventually gold and silver still have more upside.

In the meanwhile, I wish you all the very best of luck with your trading.  As I noted last week, my trading team has been doing well, and if you are interested in learning more about them, please don’t hesitate to reach out to me at akrieger@edenridgetrading.com