The Rude Awakening
Laguna Beach, California
Friday, March 9, 2007 ------------------------- - The downside to carrying yen,
- The upside to carrying GOLD,
- Risque, gratuitous photos as promised, and plenty more…
------------------------- Eric Fry, Reporting from Laguna Beach, California… Today's edition of the Rude Awakening takes a peak under the hood of the "yen carry trade." Your editors have prepared a couple of colorful graphs to try to spruce up this seemingly drab and tedious topic. But since graphs, alone, might fail to render today's discussion sufficiently interesting, we've decided to include a couple of gratuitous, risqué photos that have nothing whatsoever to do with the yen carry trade.
Gratuitous, Risqué Photos 
After viewing the photos above, you might assume that today's column would be all downhill from here. But actually, we may have saved the sexiest material for last. We admit that the yen carry trade sounds pretty, darn boring…and unimportant. But in fact, it can be as exciting as a bungee jump (with or without a rope) and has become one of the most influential phenomena within the global financial markets. To kick things off, we'll hand the editorial reins over to Bill Bonner, the ever-enlightening editor of the Daily Reckoning: "Watch out; the yen is rising! "Here's our theory: hundreds of billions of dollars are caught up in the 'carry trade'. Speculators borrow yen at preposterously low interest rates. 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. Then, the speculators get spooked and begin to look for the narrow door that leads out of the trading room. In the best of cases, they exit in an orderly fashion, selling their high-yielding investments and buying back yen so they can repay their loans. Dollars, pounds, and New Zealand dollars go down. Yen and Swiss francs (another low-interest rate currency borrowed for the carry trade) go up. "You will know when the game is over, dear reader, when you see the yen and Swiss franc rising. "Recently, both seem to be moving up. The British pound, on the other hand, took a step down. So far, the movements are so orderly they haven't even been noticed. But watch out…if something goes really wrong, speculators will make a mad dash for the door and many will be crushed. "Last week's mini-crash in China scared a few speculators. U.S. stocks, for example, got hammered down below where they began the year. The stocks and bonds of the money shufflers - Goldman, Morgan Stanley, Merrill Lynch - seem to have topped out. "The real action may come today, tomorrow…or a year from now. But when it comes, you will be better off holding yen and Swiss francs than dollars or pounds. Sterling looks particularly risky to us - since so much of the hot money of the money shuffling trade has found its way to London. "In the meantime, we note another curious thing…gold is getting clobbered too. How could that be? Remember, there's no magic to the yellow metal. It goes up and down like everything else. Gold is money; it represents purchasing power. The excess liquidity pumped into the world economy by the central banks, the carry traders, and the financial industry represents a kind of inflation of purchasing power, too. "And when inflation increases, so does the price of gold - typically overshooting. A collapse of the liquidity bubble, on the other hand, represents a decrease in purchasing power…a deflation. Gold will not necessarily go up when that happens; it could go down. People will need cash to pay their debts. Cash, for Americans, means dollars. "We don't buy gold because we think it is going up (though we do think it is going up). We buy it because we see the financial world as much riskier than most people think. Inflation…deflation…we expect some kind of 'flation' as a result of all the debt and credit pushed onto the world over the last 15 years. "Remember, a correction should be equal and opposite to the deception that preceded it. This new 'liquidity' - trillions of dollars worth - pretends to be real money. It is not. It has no resources…no real savings behind it. Since it is not real…when the correction comes, it will disappear - along with many of the 'assets' and much of the 'wealth' that people today think they have. The good thing about gold is that it will still be there." Joel's Note: How gold must laugh at our feeble, ignorant attempts at replacing her with paper as a store of wealth. The precious metal has witnessed the rise and fall of the currencies of history and still she remains. She has watched our deceptive game of dressing paper up as if it were an honest mark of value. We're always on the lookout for new ways to diversify away from the ever-fluctuating currency markets and, invariably, gold comes up as one of the best dollar hedges. Now the folks over at Outstanding Investments reckon they've found what they call, "zero-downside" gold…a way you can invest in the ultimate store of wealth with no risk. If you are interested, you can read the full report right here:
---------------------------- Grable, Gable…and Yen
By Eric J. Fry Because professional investors may borrow money in yen at interest rates of less than 1% per year, they do. These folks borrow hundreds of billions of dollars worth of yen and then buy any stock, bond, commodity or derivative that seems likely to produce a return greater than 1% per year…hopefully, much greater. This pursuit is known as the yen carry trade. "The yen carry trade might seem somewhat complicated," we remarked in yesterday's column. "But it's not complicated at all. In fact, it's so simple it's almost moronic." Since 1% is not much of a hurdle to clear, investment-wise, the yen carry trade seems like a no-brainer to rocket scientists and hedge fund managers alike. But this leveraged financial maneuver is not risk-free…even if it may appear to be for long periods of time. Let's imagine, for example, that an investor with $1 million wants to leverage that sum into $4 million. So he borrows $3 million worth of yen at 1% per year. (For perspective, one-year Japanese government bonds yield a miserly .64%, while 5-years yield 1.17% and 10-years yield 1.63%). Let's then imagine that he uses his $4 million to buy T-bills yielding 5%. A 5% yield on $4 million produces $200,000 of interest. After subtracting the $30,000 of interest paid (i.e., 1% on $3 million), the investor would have received a net $170,000, or a 17% return on his $1 million of actual capital. That's not too bad for T-bills. But there's a wrinkle. The yen's value is not set in stone. In fact, it's not set in anything other than the whims of the financial markets. If the dollar's value against the yen were to fall even 4% during the course of a year, our hypothetical CD-buyer would begin to lose money. A 5% drop would produce a $30,000 LOSS…and some concern. A 6% drop would produce a $70,000 loss…and mild panic. And let's remember that the real-world pain that our hypothetical speculator might endure could be much more excruciating than our example suggests. A 6% drop would produce an immediate $240,000 (24%) hit to his capital, while the $170,000 he hopes to pocket on this trade would merely trickle in bit-by-bit each month. So if our speculator were to suffer a sudden hit to his capital, he might not be inclined to continue risking it for the sake of recouping $170,000 over the ensuing 12 months. That's why a 10% drop in the dollar/yen exchange rate could produce a run for the exits…from a wide variety of carry trades. "What are the odds of a 5% drop?" you may be asking yourself. "We have no idea," would be our response, "…but it just happened." In the span of just six trading days - from February 26th to March 5th - the dollar fell more than 5% against the yen. After a move of such ferocity, chicken and egg become indistinguishable from one another. A rising yen (i.e. falling dollar/yen exchange rate) produces losses for all carry trades. These losses cause some investors to close-out their trades, which means they must buy back they yen they had borrowed previously. Their yen-buying drives the price of the Japanese currency higher, which causes more pain for the remaining carry-trade investors. A vicious cycle ensues. 
The nearby charts prove nothing at all about the relationship between the yen carry trade and the financial markets at large, but they do suggest a connection between the two. Over the last year, the dollar/yen exchange rate has closely tracked the price trend of the MSCI Emerging Markets Index. Even more provocative is the fact that major trend changes in the dollar/yen exchange rate have led trend changes in the MSCI Index by about one month. Again, this seeming connection means nothing quantitatively. It could be an accident. But if one assumes a connection between the two, what might the connection be? Perhaps it would be that a falling "dollar/yen cross" (as this exchange rate is known to professional traders) reflects, at the margin, the repayment of the yen borrowings that finance carry trades. Whenever speculators close out their yen borrowings, they would also sell-out the assets that their borrowings financed. This identical process would also operate in reverse - i.e., a wave of yen-borrowing would facilitate a wave of asset-buying. Since a yen borrowed today need not be invested immediately, it is not difficult to imagine that a lag would occur between a wave of yen-borrowing and a wave asset-buying. The opposite process - yen-repayment and asset selling - could also occur with a lag. But there's one very important difference between buying yen to finance speculations and repaying those yen. Yen-borrowing would never occur under duress, but yen repayment would. In fact, it probably did last week. If yen-financed assets dropped suddenly and sharply, this slide could easily produce the sorts of losses that would trigger margin calls and forced de-leveraging of speculative positions, including the forced de-leveraging of yen-financed positions. 
We find it curious, therefore, that the dollar/yen cross has adopted such a close real-time relationship with the trend of global equity markets. The nearby chart depicts the price trends of the dollar/yen cross and the S&P 500 since the beginning of the year. Over this very brief timeframe, these two financial items have become something of an item themselves. They're like synchronized swimmers. But it looks like these swimmers are struggling. In fact, it looks like the yen carry trade might be on the verge of drowning…and of dragging its partner under water in the process. --- Carry Gold - Not Yen --- "I'm so sure gold will soar higher, I'll even make you a guarantee … plus I'll give you 5 entirely new ways to play the trend…" "Including one way to own gold that comes with ' zero-downside' risk…" (But you have to jump on this before March 20, 2007… or the doors on this could slam shut to you forever…) Click Here For The Five Most Profitable Ways To Play Gold -------------------------------- | 
