Archives: 2007 August

The carry trade developed out of the depression and deflationary period that Japan has endured for most of the past twenty years.

The Japanese government insured that the Bank of Japan supplied copious amounts of low cost credit to the Japanese economy in an effort to fight domestic deflation. During most of this easy money time period interest rates were near zero in an effort to stimulate domestic demand.

International financial operators soon learned that they too could take advantage of the low interest rates being offered in Japan. They were soon borrowing huge sums in Yen from the Bank of Japan, converting the Yen into Dollars, British Pounds, Euros, and high yielding currencies like Kiwis and the Australian Dollar, and then investing the proceeds in high yielding financial investments.

At first the proceeds of the loans originating in Japan were used to invest in traditional financial instruments, like US Treasury bills and notes. However, as what was considered by many carry trade operators as a “free lunch” continued large amounts of funds begin to flow into all sorts of real estate investments, mortgages, and hedge funds that had great flexibility as to how they could invest the funds.

So what started as a domestic Japanese operation used to fight deflation morphed into an international financing mechanism favored by the world’s “smart money” crowd. The sums involved with carry trade investments become so large that a great many people around the world became quite rich by collecting fees and commissions from the placement of these funds.

USD/JPY Strength Forecast for next week.

The USD/JPY closed today at 116.42. A close above 116.25, 116.30 turns the momentum back to the upside with the recent high of 117.13 a target for next week.

The hourly, daily, and weekly charts are now pointed in the same northerly direction for US/YEN. I would look to be a buyer of USD/YEN on the dips and look for a nice move to the recent highs.

The US economic releases today were surprisingly strong. The US Commerce Department said that new home sales rose to an annual rate of 870, 000 in July. This was a 2.8% increase from the June rate and well about expectations. In addition, the US Commerce Department stated that durable goods orders rose by 5.9% in July. This was a much higher number than expected by economists.

The strong economic data helped to fuel a stock market rally that took the Dow industrial averages to 13.378.78. up 2.75% for the week. Concerns about a liquidity crisis seemed to have abated by weeks end.

There seems to still be a high degree of correlation between USD/YEN movements with the Dollar gaining against the Yen on strong stock market rallies and falling as stocks pull back. With the Dow closing above the closely watched 13,300 resistance level look for a positive start next week for stocks and USD/YEN.

However, a word of warning.  The liquidity that quickly surfaced as the sub prime mortgage housing lending market came unhinged can quickly return. The forced liquidation of carry trade positions can spread to all asset classes , like marketable stocks, as hedge fund operators are forced to sell good assets because such a large percentage of their funny money derivatives portfolios are not readily marketable.  

The surprise move by the US Federal Reserve Bank to cut the Fed Discount Rate by half a percentage point on Friday helped to rally the stock market but actually is more of a symbolic move than one that will improve financial market liquidity.

The Fed cut the discount rate in order to bolster confidence among investors and as an effort to restore orderly trading conditions in the stock market, but the Fed Discount Rate cut has no meaningful action on the commercial paper market. Michael Englund, principal director and chief economist with Action Economics LLC. had this to say. “A liquidity crisis is what’s underlying the commercial paper crunch,” Englund said, “and commercial paper doesn’t have access to the discount loans.”

Those stock market investors who were cheering the Fed’s move on Friday will likely be under pressure again by as early as next week. It will take far more than a symbolic gesture to repair damage already caused by a liquidity crunch that is positioned to become far worse.

The US Dollar sold off as Wall Street rallied. Look for additional Dollar strength as the sell off in stocks begins again in the days ahead. The dollar’s strength may seem strange to some in light of the US list of financial market, fiscal and trade deficit problems.

The perverted nature of this Dollar strength is discussed in a posting called Dollar Strength Forecast.

Yen carry trade panic is unfolding as Yen positions are being forced to be liquidated.

The Japanese Yen is making strong gains against the US Dollar and other currencies today, especially Kiwi and Aussie Dollars, as panic hits the hedge fund operators and others who thought that the positive carry in the Yen carry trade would last forever.

In the Yen carry trade speculators and hedge fund managers became fat and lazy over the past few years.

They were able to make loans in Yen at very low interest rates and then invest the borrowed funds into higher yielding assets. Hedge funds were large participants in the “positive Yen carry trade” as it was until very recently an easy way to get a good return.

Unfortunately, those involved in the carry trade seemed to forget that the trade carries the risk of foreign exchange exposure. For the trade to be profitable the Yen must remain stable or even better weak against the currencies that Yen is being exchanged for in order to make higher yielding investments.

Foreign exchange operators who had taken loans in Yen because of the very low interest rates are now buying back the Yen to repay those loans. That carry trade unwinding is carrying the Yen to new highs not seen since mid 2006.

The debacle in the sub prime lending market, which hedge funds are large participants in, has forced the liquidation of investments in the hedge funds portfolio. As investments are liquidated the Yen carry trade loans must be paid off. The huge problem for the hedge fund managers is that as these positions are unwound the Yen gains strength as massive amounts of Yen are being brought within a very short time frame in order to pay off the Yen dominated loans.