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 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 of 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. 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 are 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.

David Rodriguez is a Currency Analyst at FXCM.