By DailyFX – For currency traders, the relationship between the Dow Jones Industrial Average and the infamous Carry Trade is… … no secret, Currently the Dow is leading the direction of carry trades, but in the past there have been times when carry trades has led the Dow.

The month of September brings
forth a very strong seasonality in US stocks, one that could provide us
with a leading indicator of how carry trades, or more specifically the
Japanese Yen crosses will behave this month.

Relationship Between Carry Trades and the Dow

The correlation between carry and the Dow is now the strongest in 8
years. The chart below emphasizes the significance of Dow performance
versus the G-10 carry trade basket, with the current medium-term
correlation standing at its highest levels since the infamous tech
bubble burst in 1999. Given a tumble in risky high-growth stocks,
speculators across the spectrum scaled back exposure to other risky
assets including the highly leveraged global carry trade. Given a very
similar sell-off through the past month and a half, the Carry Trade vs.
Dow correlation remains fairly stable near the 0.6 mark. The reason why
these two asset classes are correlated is because they are both a
reflection of risk. When the risk appetite of the financial markets is
high, then demand for stocks and carry trades rise, but on the flip
side, when the market is risk averse, the Dow and carry trades tend to
suffer. There is no reason why this relationship should break down over
the next month, which is why the strong seasonality in the Dow during
the month September could provide very useful clues on how the carry
will trade in the month ahead.

The September Effect

In widely documented studies, September is a particularly difficult
month for US equities. Over the past 50 years, on average, the Dow Jones
Industrial Average has fallen 1.2 percent this month. Dubbed the
September Effect by the financial press, it is relatively
well-known that many large hedge funds and mutual funds will begin
scaling back exposure in stock markets so as to book profits before the
year end, especially since many mutual funds end their fiscal year in
October.

The Dow Jones Industrial Average has exhibited a remarkable trend over
the long term with September being the biggest losing month of the year,
by far. The chart below shows the stark contrast between how the Dow
behaves in September and in the other 11 calendar months of the year,.
With the exception of June, the Dow has rallied every month on average.
In fact, had the trader sold the Dow at the end of August and covered at
the end of September for 50 years, he or she would have made over 80
percent on their initial investment. This stands in stark contrast with
gains through the final three months in the year, which will typically
see the Dow improve 0.6 percent, 1.4 percent, and 1.5 percent
respectively.

A shorter term view reveals much the same trend through recent years,
with the past five years seeing the Dow Jones drop 60 percent of the
time in September. Of particular significance is the fact that the DJIA
plummeted an incredible 13.2 percent in September, 2002 an ominous
reminder that the month can be particularly disappointing for domestic
equity markets.

Can History Repeat Itself?

The evidence in favor of continued equity tumbles through September is
formidable, but will this truly be enough to sink the carry trade
further? Clearly, market jitters continue to force large moves across a
broad swath of financial asset classes. If the correlation between the
Dow and the Carry Trade holds, we could easily see funding currencies
such as the Japanese Yen and Swiss Franc rally against their
higher-yielding counterparts. This leaves a particularly bearish tone
for the previously high-flying New Zealand and Australian currencies as
well as the British Pound and, to a lesser extent, the Euro. Though we
have already seen these currencies fall significantly off of recent
heights, a Yen rally will probably be enough to force further reversals
through medium term trade.

September may be an especially busy month in terms of fundamental
forces at play. Continued market turmoil leaves trends to the downside
across all risky asset classes, with the US equity market particularly
susceptible to any news coming from the troubled domestic mortgage
lending market. Recent Home Sales data further confirms the overall
recession in the real estate sector, with the overall economic outlook
likely to deteriorate before it improves. This will be particularly
difficult for existing homeowners, who will see their adjustable
mortgage rates rise significantly when lenders reset their rates through
the end of the year. A sharp rally in the costs for borrowing will
almost certainly worsen outlook for domestic consumption and overall
growth prospects. Given such fundamental factors at play, the odds for
equity market weakness this September is particularly high. Carry
traders need to be very careful and for those looking to continue to
fade carry, a position in the Japanese Yen could turn out to be quite
profitable through the medium term. In fact, our own Senior Currency
Strategist Boris Schlossberg and Technical Strategist Jamie Saettele
suggest that this could turn out to be the best trade through the end of
2007.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

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