A continuous supply of fresh water (money) flows into the bowl from a huge tap controlled by the world’s central bankers. The bowl will lean whichever way the investors tilt it. If investors were bullish on America, they would tilt the bowl towards the U.S. and money will flow into American stocks and assets.

“In short, the direction of the overflow will depend on the bias of investors, which in turn can be manipulated by opinion leader, the media, analysts, strategists, politicians and economists.”

So as long as central banks supply the bowl with money, and as long as there are investors collectively tilting the bowl, there will always be assets that appreciate (those that are getting the money flow) and assets that fall (those that don’t get the money flow).

But what if most of that money supply flowing into the world comes from a single central bank? And what if those investors standing below it are all the same breed? Would that be too much monetary control concentrated in the hands of a few? Would such a scenario even be possible?

The central bank is the Bank of Japan and the breed of investors is Yen carry traders. Japan is the world’s largest source of capital. About $3 trillion worth of Japanese money has flowed through that bowl on top of the Earth and is invested all over the world.

The investors around the bowl are Yen carry traders. Carry trade is a transaction where speculations borrow money at a low interest rate and invest it at a higher rate, pocketing the difference. For a detailed explanation see my Sleuth article from last week.

Japanese interest rates have been 0% for a decade. That is why the world is away with liquidity originating in Japan. Japan is literally giving money away. In many ways, the Bank of Japan is banker to the world.

As a result, carry traders borrow Yen at 0% and invest it in U.S treasuries, real estate, stocks, etc. Nice free lunch, isn’t it?

But the Bank of Japan announced recently that with an improving economy, it will no longer keep interest rates at 0%. A rate hike to 0.5% is very likely this year. The announcement has already shaken up several asset classes. See my article from last week for how it affected Iceland and other emerging markets.

A 0.5% increase in Japanese rates in nominal terms, is no big loss to a carry trader. But let’s not forget that there’s a tremendous multiplier effect here.

The profitability of carry trade depends on, apart from the interest rate spread, one other factor — exchange rates. For a carry trader to make money, the Yen needs to be weak and the dollar strong.  For the past two years, the opposite has been true — the Yen is appreciating against the dollar. That means, the carry trader now needs to pay back more Yen than he originally borrowed. Therein lies the problem.

Back in 1998, Yen carry trade was at its peak. Speculators were borrowing Yen at 0% and investing, among other places, in Russian debt. The Berlin Wall had fallen and Russian junk bonds had extraordinarily high yields. Borrowing Yen for nothing and investing in Russian junk bonds seemed like a foolproof idea. As long as Russia kept paying its debt, of course.

But then it didn’t. Russia defaulted on its debt. Panicked speculators rushed out of their trades. As a result, the Yen appreciated 20% in just two months. Yen carry traders who were essentially short the Yen, were rushing to liquidate their positions.

According to an article on Fnarena.com, “Massive paper profits became massive crystallised losses overnight [after the Russian default]. Speculators climbed over each other to pay back their yen exposures and the yen rallied 20% in less than two months. One of the U.S.’s biggest hedge funds, Long Term Capital Management, collapsed with billions owed to a string of respectable U.S. investment banks. The Fed had to step in and prevent financial catastrophe by shoring up the system with cash. Otherwise the domino effect may have seen the collapse of the whole world financial system.”

That’s what a strengthening Yen (or falling dollar) can do. Today’s global financial system is faced with a double threat. Japan is raising interest rates. And the Yen is appreciating. Both trends also seem secular and sustainable. Japanese interest rates are at zero; they can only go up. And with the dollar in a long-term bear trend, the Yen can only go up against it.

Consider this highly probable scenari Bank of Japan raises rates to .5%. In the U.S., the Fed cuts rates to keep the housing bubble from bursting, causing treasury yields to fall from the current 5% to 4%. That means a Yen carry traders profits are now 4 minus 0.5, which is 3.5%.

Now, a mere 3.5% rise in the Yen against the dollar will wipe out all the profits. Remember, the Yen has risen as much as 20% in just two months under precisely the same circumstances.

That spells doom for Yen carry traders. Not only is the spread between Japanese and other yields contracting, a strengthening Yen will increase the cost of borrowing for carry trade. Any change in monetary policy and the Yen carry trade will come crashing down. And just like it did in 1998, it could undo global financial systems.

Here is a chart and analysis of the Yen by Greg Silberman on Kitco.com:

“Yen is looking very BULLISH. The Yen has formed a massive right angle triangle formation. Over an 8 year period the floor on the Yen has steadily risen and now stands at 85. The ceiling has remained around 100. Whoops! This POWERFUL chart suggests the Yen is more likely to rise than fall over time.

“The drop from roughly 2004 to 2006 (red rectangle) accounts for the MASSIVE Yen trade we are talking about. Hardly a Free Fall!

“The recent Global Stock Market Wobble, courtesy of a rising Yen can be seen in the blue rectangle. Can you imagine what would happen if the Yen really took off?.”

Yes, I can unfortunately. With the end of the Yen carry trade, speculators will pull out of all investments they made using borrowed yen. As a result:

1. Anything purchased using borrowed yen will fall. U.S mortgage debt, bonds, stocks, emerging market equities, Shanghai real estate have all already taken a dive due to a pull out earlier this year.

2. Carry traders repaying their yen debt will strengthen the yen in the long run.  According to  David Bloom, currency analyst at HSBC, “If any currency is going to appreciate over time, it will be the yen.”

3. That means businesses that have costs in dollars but revenue in yen will make higher profits.

4. Domestic demand stocks (and any business that is not export dependant) in Japan will also do well as a result. Japanese bathroom accessories maker, TOTO is worth putting on a watch list. According to Morgan Stanley, “wait for dips to buy domestic demand stocks.”

While the world frets and flees with the end of Yen carry trade, you can actually make money if you follow the macroeconomics trends. Like Marc Faber said, all that money flowing through the bowl on the top of the world needs to go somewhere.

Regards,

Sala Kannan
July 14, 2006

All Liquidity Leads to Japan was originally featured in the Penny Sleuth.