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There is a very important
development regarding the YEN carry trade. I deem this important
enough to post a market crash alert.
The Japanese economy is strengthening enough
to cause an unwinding of the massive YEN carry trade. The
last time this happened, there was the LTCM collapse.
Japan has had enough economic growth these
last quarters, in production growth and consumer spending,
that the BOJ may well end the policy of zero interest rates
in Japan.
That zero rate interest policy has lasted
about ten years, and is the first source of the liquidity
bubbles world wide, and is very much a part of the liquidity
bubbles here in the US. Once the BOJ starts to raise interest
rates in Japan, the Yen carry trade will start to unwind.
The Yen carry mechanism is to borrow Yen at
virtually zero rates, and then to purchase US treasuries
at about a 3% interest rate gain net. There are literally
trillions USD of yen carry trade positions scattered amongst
hedge funds, insurance companies, and mutual funds. The
phenomena is so widespread and has gone on so long, that
the BOJ and even the BIS does not have data on the known
net amount of YEN carry trade floating out there in the
world. The result is that the effects of an unwinding of
the Yen carry trade are unknown, but are sure to be very
negative.
Here are the kinds of things that will happen
when the Yen carry trade is unwound:
• US treasuries will become less desirable,
much of the purchases of UST’s last year were from
foreign private entities who bought the UST’s to benefit
from the interest differential of about 3% net over Japan.
• UST’s were not the only beneficiaries
of the Yen carry trade. Markets world wide are given massive
amounts of liquidity, as Yen borrowed for virtually nothing
are then invested eventually in foreign stock markets everywhere.
Real estate markets also benefit greatly, as the Yen carry
trade finds its way into real estate markets from Shanghai
to the US to everywhere. The BOJ literally acts like a central
bank of the world through the Yen carry trade, supplying
liquidity that finds its way into markets everywhere.
The phenomena is a decade old now for the
latest manifestation. The last time this level of penetration
of the Yen carry trade was reached was just prior to the
LTCM collapse. Back then, when the Yen unexpectedly strengthened
20% it caused a massive move out of Borrowed Yen on the
Cheap, and caused massive market sell offs world wide, and
was a direct cause of the LTCM collapse, where the US FED
had to act immediately to bail out banks and illiquid brokerages
and financial entities with blank checks to forestall that
crisis.
We are again facing a very similar dilemma
now, with the present significant strengthening of the Japanese
economy, and the prospect of a rising Yen and a rising Japanese
interest rate environment. Both of these trends hit the
Yen carry trade on two sides.
This could cause a massive move out of the
Yen carry trade, as those positions are unwound quickly
to get out in advance of as many others as possible. This
is because that Yen carry trade has gone on for about ten
years and the accumulated positions are just astronomical.
It is for this reason that I am issuing my
third market crash alert for 2006.
I don’t like issuing these, but when
I see such an event pending, I just have to give the alert.
This is not something I like doing. An alert does not mean
there must be a crash, only that there is a serious new
risk of one.
Here is a link to a superb article at Bloomberg
about this issue. I have paraphrased some of it above.
“Bloomberg: Remember 1998
In October of that year, Russia's debt default
and the implosion of Long-Term Capital Management LP shoulder-checked
global markets. The disorienting period culminated in the
yen, which had been weakening for years, surging 20 percent
in less than two months.
Suddenly, just about anyone who'd borrowed
cheaply in yen rushed for the exits. It prompted frantic
conference calls among officials in Washington, Tokyo and
Frankfurt. Just how big was the yen-carry trade? How much
leverage was involved? What could policy makers do, if anything,
to regain control?
Since then, the wild days of 1998 have been
largely forgotten. And as Japan slid back into recession
and deflation, the yen-carry trade was back in favor. Trouble
is, just as then, officials have little data to go on to
understand the enormity of the risks all this poses. “
http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_pesek&sid=a0gK4Vt__cBU
Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com
****
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