The Financial Times headline (Mar. 2) mentions that a "stronger yen raises fears over global carry trade," as a cause of the trading frenzy in markets across the world.
We totally agree. The yen carry trade may take time to unwind, but its implications are enormous.
[Editor's Note: Can Ben Bernanke avert the coming currency crisis?]
We have long mentioned the massive amount of low cost liquidity as a commonly held justification for taking investment risks that we have thought imprudent. Total bank credit in the U.S.was some $3 trillion in 2001. By 2007, it had risen by almost 300% to $8 trillion!
In the January issue of our sister publication, Financial Intelligence Report, we repeated a most important quotation by Stephen Roach of Morgan Stanley, referring to excessive liquidity.
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Roach said, "There is one word that permeates virtually every discussion I have with investors around the world — liquidity. It's really the only thing they want to talk about."
He then added, "In the view of most fund managers, liquidity remains more than ample to support ever frothy markets — irrespective of the outcome for the global economy.'
Roach ended with a statement that we support entirely and have long tried to communicate to our readers. It was. "For my money, the risks of the global fizzle are being taken too lightly."
Following 9/11, the major central banks of the world agreed to provide liquidity at low cost. We agreed with that protective measure against financial panic.
The problem was that governments found this economic "aspirin" useful in reducing the political pain of other actions, such as the disastrous war in Iraq and profligate government spending.
The U.S. government in particular continued the provision of massive amounts of historically low cost liquidity. Money supply increased to the point that our government ceased to publish the broad M-3 figures, making it difficult to monitor.
It is now 6 ½ years since 9/11, but the provision of low cost liquidity has continued at an imprudent pace.
One of the most important providers of this liquidity has been the bank of Japan.
Japan's economy, the second biggest in the world, had gone into a prolonged slump.
In order to stimulate domestic demand and climb out of a major slump, the Bank of Japan reduced its interest rates to one percent.
This was some three percent below the cost of credit in other major currencies. It caused the value of the yen to fall.
So Japan was providing credit at 1 percent to any borrower in a currency that was falling. This was most tempting to both domestic and overseas institutional borrowers, including (hot money) hedge funds.
The Bank of Japan therefore became the "kind banker" to the outside world, providing massive additional liquidity to the world.
Yen, costing just one percent, were borrowed, converted into dollars — putting further downward pressure on the yen — and invested even in short-term U.S. Treasuries at a positive income carry of some three percent and the prospect of repayment in cheaper yen, offering a capital gain. Not a bad deal, right?
It became know as the "Yen Carry Trade."
The almost reckless greed that appears to permeate most of today's markets meant that this cheap money was poured into increasingly speculative prices for bonds, stocks, and commodities.
Worse still, it encouraged speculators to borrow more and leverage their positions to amounts that would normally be considered alarming.
However, as prices appeared to rise continuously and institutions, especially banks, were awash with cash, more money was lent.
Of course, the big risk was of a revaluation in the yen.
The only other major carry trade with such a fine positive carry was the "Gold Carry Trade."
However, the Gold Carry Trade is limited to just a very few so-called "Bullion Banks" who are permitted to borrow gold from central banks at some one percent, offering vast profit potential.
However, the price of gold has been rising, threatening the current income profitability of these vast gold carry deals.
(The Bullion Banks include several major investment banks, such as Goldman Sachs and Morgan Stanley. We are more than interested that Bloomberg reported Friday (Mar. 3) that traders at Goldman, Morgan, and Merrill Lynch, have "priced the credit-default swaps linked to the bonds of their own companies at levels that equate to debt ratings of Baa2. That is five levels below the actual Aa3 rating on their senior unsecured notes and two steps above non-investment grade, or junk."
What, we ask, do these in-house traders know that we do not?)
[Editor's Note: A run on the dollar has already begun. Protect yourself now.]
Back to the Yen Carry Trade, which we understand supported massive investment not only in long-dated U.S. Treasuries (causing an inverted yield curve), but also in stock markets and commodities.
Recent news from Japan is that Japanese household spending has increased.
This opens the specter that the Bank of Japan, already under pressure from major central banks to stop the erosion of the yen, may raise its interest rate.
This would not only cut into the current profitability of the Yen Carry Trade, but far more worrying, is likely to cause the yen to rise with the potential to smash into the lucrative total returns of the Yen Carry Trade.
As the Yen Carry Trades unwind, they will put great downward pressure on U.S. Treasuries, international stock markets and commodity prices and upward pressure on the yen as borrowers buy the currency to repay their debts.
World stock markets are very nervous (with over 2 billion shares trading on the NYSE on two consecutive days) and the prices of many key commodities are falling. Traders and commentators in the media ask openly, "Where is all the selling coming from?"
We wonder that they took so little time to ask where all the buying power was coming from on the way up.
Larry Kudlow referred on Mar. 1 on CNBC to the fact that a falling gold price indicated a falling inflation rate.
Were could not disagree more strongly. Anyone that agrees with that proposition has failed utterly to appreciate that the price of gold is not a free market price.
As our readers will know, the price of gold, like the CPI, is a cooked book. The price of gold has been held down for years by concerted international government action, led by the United States.
As our readers will know well, our concern is that 2007 will be the Year of Financial Reckoning, with speculative stock and commodity markets plummeting and the price of gold rising fast.
In light of this we urge our readers to think conservative and slant their investments towards cash, short-term high coupon, quality bonds, and gold.
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