Tuesday, September 4, 2007

Yen Carry Trade Meltdown Could Cause Yen to Soar

A lot of people wonder where in the world to put money given that all asset classes are bound to fall in value very soon.
Here is one idea...

This from Eric Fry at The Daily Reckoning

Is the stock market scaring you? Buy yen.

If the connection between falling stocks markets and a rising yen confuses you, don’t be dismayed. You have a lot of company. But the connection is not as confusing or sophisticated as it might seem. The “yen carry trade,” as it is known, only seems complicated. But it’s actually so simple, it’s moronic.

“Speculators borrow yen at preposterously low interest rates,” explains Bill Bonner. “They trade the money for other currencies - notably those of English-speaking countries - in order to place the money in higher-yielding investments. They then pocket the difference and think they are geniuses. The game works beautifully. Nothing goes wrong. That is, until something goes wrong.”

Two weeks ago, as global stock and bonds were tumbling, the “EXIT” door became jam-packed…and the yen’s price soared. If assets prices worldwide continue to tumble, the yen carry trade will continue to unwind. And if the carry trade unwinds, the yen will soar. Buying yen, therefore, offers a back-door hedge against falling stock and bond prices. One simple way to buy yen is to purchase the CurrencyShares Japanese Yen ETF (NYSE: FXY).

For several years, the yen carry trade has nurtured and facilitated risk-taking throughout the world’s financial markets. It has provided a seductive source of low-cost liquidity that has emboldened speculators to borrow yen at dirt-cheap rates of interest and invest the proceeds in higher-yielding investments. As long as the “higher-yielding investments” obliged with high-yields, the process worked beautifully. And it had been working very beautifully… until about four weeks ago.

But now that stocks and bonds become very volatile - or simply falling - many yen carry trades are producing losses. As the losses mount, the pain is increasing. As the pain increases, the speculators begin to sell their “high-yield” assets and repay their borrowed yen.

Obviously, the process of repaying yen requires buying yen first, then giving them to the lender. That’s why the yen appreciates during times of market distress.

For example, in mid-July the yen fell to a record low against the dollar on the very same day that the Dow reached its all-time high above 14,000.

But as stocks tumbled from their all-time highs, the yen’s value rocketed higher. The more stocks fell, the more the yen rose; the more the yen rose, the more stocks fell. After a while, cause became indistinguishable from effect.

The yen’s recent spike might be signalling that rampant risk-taking is winding down.

“People are taking risk off the table,” one currency trader told Bloomberg News, “In this environment, the yen carry trade is suffering and is going to continue to suffer.” The “suffering” of the carry trade does not move us to tears.

“The big carry trade beast has started to roar,” says Albert Edwards, an investment strategist with Dresdner Kleinwort, “A complete meltdown of the Yen carry trade now beckons.

“So far,” Edwards continues, “the ‘Great Unwind’ has not seen a major reversal of Yen-funded trades. Much else has happened, but this is the elephant that has been waiting to trample its way through the global financial village and squash the villagers already dying of thirst from a liquidity drought.”

Avoid the stampede; buy some yen.

Eric Fryfor The Daily Reckoning Australia


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