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Japanese Yen The Biggest One-Way Bet of All Time

Currencies / Japanese Yen Aug 24, 2007 - 10:25 AM GMT

By: Money_and_Markets

Currencies Best Financial Markets Analysis Article

Jack Crooks writes: Since Mike Larson is off today, he's asked me to fill in for him. And his request couldn't have come at a better time: My specialty is foreign currencies. Foreign currencies have been surging against the dollar. And we're on the verge of a very specific currency explosion that could generate one of the greatest profit opportunities in a quarter century.

Here's the scoop:

The world's largest hedge funds and the world's richest institutions have been borrowing massive amounts of cheap Japanese money to fund some of the riskiest bets of all time. And now, that whole mountain of debt and risk is starting to crumble.

Mind you, this is no overnight phenomenon. It's been building up virtually nonstop for over 14 years!

Because of a 14-year recession in Japan, their interest rates have hovered close to zero — the longest period of the lowest interest rates of any major industrial nation in memory.

As an investor, imagine what you could do with that much "free" money offered continually for so many years …

Even if you just bought U.S. Treasury bonds, you could sit back and earn a couple of extra percentage points a year …

Or, you could plow the money into stocks and play for double-digit returns every year …

Or why stop there? You could go whole hog and leverage your bets with all kinds of fancy derivatives to aim for returns that would put the stock market gains to shame.

This is precisely what has helped hedge funds get so rich so quickly. This is the "Big Game" U.S. major banks and Wall Street brokerage firms ran to for what they thought were "easy" profits. With this "yen carry trade," as it's called, they essentially borrowed money in yen, converted it back to their own currency (e.g. the U.S. dollar), and then used the proceeds to place their big bets.

Just how much money is tied to the yen carry trade? Some estimates put the total value of yen-denominated borrowing at more than one trillion U.S. dollars! And those estimates don't account for the hundreds of billions in loans that are linked to these investments via margin credit and derivatives.

Indeed, I think it's fair to say that this is the biggest one-way bet in the history of the financial markets . And yet, too many investors have assumed for too long that it's a "risk-free ride."

How quickly they forget!

Back in 1998, in a Very Similar Credit Crunch Like Today's, the Yen Carry-Trade Came Unglued! Result: A Sudden Explosion in the Value of the Yen

In 1998, the yen staged a massive rally as hedge funds were forced to unwind big carry trades. The trigger was different — the Asian financial crisis. But the consequence — a sudden credit crunch — was very similar to what you see happening today.

The yen skyrocketed, jumping in value against the dollar by about 20% in a little over a month. Then, as you can see in the chart, even after the initial surge, it continued rising for almost an entire year.

Now it's about to happen again, and this time around, the trigger will be the credit crunch that is unfolding right before our very eyes, but with two critical differences:

First, the size of the one-way bet against the yen today dwarfs the amount of money that was involved back in 1998.

In 1998, it was estimated there was about $137 billion in Japanese yen carry trade borrowing. Today, as I just told you a moment ago, that number is estimated at $1 trillion!

Second, the level of investor complacency is far greater than it was in 1998!

Global financial markets have been so calm for so long, and global growth has been so strong, investors are really not that worried about any of this right now … even after the market's recent choppiness.

See, the hedge fund "pros" seem to have convinced themselves that the yen won't rally until Japanese interest rates go up.

Baloney! In my opinion, the rally in the yen will be first and foremost tied to risk coming to the fore of global financial markets. That's SURPRISE #1 .

SURPRISE #2 will come as the Bank of Japan actually goes ahead and hikes interest rates more aggressively, catching most investors off guard.

I'm not talking about a huge increase, mind you. But it doesn't have to be huge. All you need is a minor hike to change the profit picture for many of the borrowers.

These borrowers will be squeezed from both sides. They'll be forced to close out their bets because of the sudden increase in risk. And they'll come under even greater pressure to close them out because of the higher financing costs.

But remember: BEFORE they can pay back all those loans to Japanese lenders, they first have to convert their dollars (and other home currencies) back into yen.

You can probably see where this is going: The unraveling of all these bets against the yen would trigger a massive yen rally.

Together These Two Surprises Mean the Yen Could Rocket Faster And Farther Than It Did in 1998!

Back then, Japan was locked in the grips of deflation … interest rates were kept low … and despite all that, the currency still rallied for more than a year.

This time, Japan's economy has solid growth momentum … the deflation is gone … and it's almost inconceivable that the Bank of Japan could hold interest rates down.

The undeniable reality:

Japan's Economy Is Steadily Emerging from a Prolonged Hibernation

Until recently, Japan was still recovering from a period of deflation, which began in 1989. So Japan's central bank was reluctant to hike interest rates very much, fearing that the deflation bear would grab hold again.

That's why, so far, all they've done is to enact two quarter-point rate hikes, bringing the current rate to a paltry 0.5%. That's more than zero . But it's still far lower than the equivalent rates in all other major countries.

And now, all that's changing. As the country kicks into overdrive, the Bank of Japan will have no choice: It will have to raise rates to keep inflation at bay.

Look: Even after its extended slumber, the country still boasts the world's second-largest economy. Only one economy in the world is larger — the U.S.

And among the world's largest economic powerhouses, there's none other that's better positioned to take advantage of the Asian boom. That's why …

Japanese exports were up 11.7% for the year ended July 2007, which tells us that business is cranking.

Japanese exports to China jumped a whopping 21%, and they're poised to rise further.

Japanese imports were up 16.9% over the same period, indicating that consumers are back in the game and spending money.

Profits at Japanese corporations have grown to the highest level in four years.

Even better, Japanese companies have reinvested those profits back into their business, opening up the door to even stronger growth down the road.

All these signs point to blue skies ahead for Japan, and most importantly, for the Japanese yen. Bottom line …

Even WITHOUT the Explosive Buying From the Huge Payback of Borrowed Yen, It's the Most Undervalued Major Currency In the World

Measured in terms of purchasing power parity (PPP*), the yen is more than 30% undervalued against the dollar, and even more undervalued compared to the world's other major currencies.

I've been following this indicator ever since I started specializing in currencies decades ago, and I can tell you flatly: When a currency becomes undervalued by 20%, it's a telltale sign of an imminent surge.

So with the yen now lurching into the 30% undervalued range, that tells me it's got built-in spring-action of massive force.

My conclusion: If you're searching for long-term value in the currency market, your search should end with the yen. I repeat: It's by far the most undervalued major currency in the world.

And that's without considering any other factor! Plus …

Rate hikes from Japan's central bank will only make it more attractive to investors …

And the possibility of massive yen carry trades unwinding could spark a rally of epic proportions.

The best part of all this is that there are terrific ways for you to capitalize on any move in the yen. In fact, profiting from currency shifts is much easier than ever before.

You no longer need a massive bankroll to get started. You no longer have to expose yourself to unlimited risk. You no longer even need a special brokerage account. You can profit from currency surges with tiny investments, strictly limited risk and peace of mind.

My recommendation: Learn as much as you can about this as soon as you can . Then move swiftly.


By Jack Crooks

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29 Aug 07, 22:35

The problem with saying the yen is 'undervalued' is there is no one good way to determine what that value should actually be.

The yen has stayed relatively weak against the dollar compared to the euro, but if the yen increases by 30% against the dollar, the economy here in Japan TANKS, for sure.

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