Last summer, a currency on the other side of the world threatened to knock the U.S. bull market off the rails…
In an unexpected move, the Japanese yen took off… and blew up the “carry trade.” As you might remember, that was a technique popular with big-money investors. They would borrow yen at a low interest rate to make a bigger profit from buying U.S. stocks.
The situation kicked off massive selling in U.S. markets. The CBOE Volatility Index (“VIX”), known as the market’s “fear gauge,” spiked to its highest level in years… And the S&P 500 Index nearly entered a correction, dropping 8.5% in less than a month.
Fortunately, the selling didn’t spiral into a worst-case scenario. But now, the yen is facing another rare setup.
The currency is now more loved than ever before. And according to history, that means a major decline is about to begin.
How Human Nature Drives Markets
It doesn’t take decades of market experience to understand why sentiment gets overheated. It’s human nature.
We’re social animals. So when we see lots of other folks doing something, we want to follow them. It’s how we fit in… by making choices that feel safe. The desire is so strong that proper analysis goes out the window.
That’s why markets get overheated. Everyone follows the herd until, eventually, there’s nobody left to buy… and the trend must reverse.
This can happen in any corner of the market. And right now, it’s happening in the Japanese yen.
We can see it by looking at the Commitment of Traders (“COT”) report. This weekly report shows what futures traders are doing with their money.
Like everybody else, these folks tend to herd together. And when they’re all making the same bet, it pays to be a contrarian…
Last month, these folks were the most bullish they’ve ever been on the yen. Take a look…
Sentiment toward the yen was hugely negative last year. But the currency has jumped in value since then. And that means lately, futures traders have been extremely bullish.
According to history, this is not the time to follow the crowd. Similar setups – which I’ve highlighted in the chart above – were terrible times to bet on the yen. Here’s what happened after those three setups…
When traders are all betting on a higher yen, the currency tends to fall. And in these cases, we usually see a quick decline of around 10%.
What’s more, two of these setups happened at the beginning of major, long-term declines. In 2011 and 2021, the yen was beginning a multiyear slide. It ultimately lost more than a third of its value.
That kind of crash isn’t guaranteed this time around. But futures traders are far too bullish right now. And that makes a quick, double-digit decline likely.
Good investing,
Brett Eversole
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Source: Daily Wealth
