The S&P 500 index, the German DAX and, especially, Japan’s Nikkei 225, have all bounced off the early August lows.
That’s classic pullback behavior, says Christopher Watling, the chief executive and chief market strategist of Longview Economics. “Most pullbacks typically follow a three-wave pattern: An initial ‘wave one’ of selling; followed by a ‘wave two’ relief rally (in which some of the ‘wave one’ losses are retraced); and then a ‘third wave’ back to the wave one lows, or lower,” he says.
Also classic behavior was that the safe-haven assets — notably the yen USDJPY and the Swiss franc USDCHF — sold off at the same time. But Watling says his firm’s “safe havens” positioning model still shows a capacity for a further shift toward safer assets.
So the question is whether the third wave will come, and what could trigger it. Dhaval Joshi, chief strategist of BCA Research’s Counterpoint service, says an analysis of the “price complexity” shows that the yen carry trade and the AI bubble are one and the same trade, and that any of three factors could torpedo it.
He notes that when investors have been selling the Japanese yen, they have been inflating the valuations of AI stocks. He shows that by overlaying moves in the euro/yen to the ratio of the 30-year Treasury yield to the forward earnings yield on U.S. tech stocks.
“While the seller of the yen might not be the very same person that is buying AI stocks, the selling of yen and the inflating of the AI bubble are two ends of the same trade process. Selling yen is facilitating the AI bubble and the AI bubble is facilitating the selling of yen. So, the relationship is not so much causation as reflexivity,” he says. “The merging into one of the yen carry trade and the AI bubble is significant because all bubbles need leverage. And in the AI bubble, the leverage has been coming from borrowing yen.”
Granted, Bank of Japan officials have said they won’t lift interest rates anymore while the market is unstable. But the yen is still vulnerable if other central banks cut their interest rates, and obviously, that’s a possibility as investors debate if the U.S. Federal Reserve will cut interest rates next month by a quarter percentage point or half-point, following rate reductions from the European Central Bank, the Bank of England and other central banks.
The other point Joshi makes is that the euphoria around AI stocks depends on how quickly it benefits the companies that are investing in the product. He notes most of the tech stock superstars of early 2000 — Intel, IBM, Oracle and Cisco — have faded, with only Microsoft transitioning to become a big winner of Web 2.0. He says of today’s superstars, Nvidia is unlikely to be a long-term winner, and only one or two at most will be a big winner from AI. “Meaning that the inflated aggregate valuation of the superstar stocks is in peril, especially as the valuation inflation has been fuelled by the yen carry trade,” he says.
For Joshi, any of the three legs — Japanese interest rates, the Japanese yen and the high-returning investment (AI) — could buckle, and once it does, “the whole stool will collapse.”