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Market Oracle FREE Newsletter


The US Debt and Yen Carry Trade Unwinding Time Bomb is About to Explode!

Stock-Markets / Financial Crash Jan 24, 2008 - 11:43 AM GMT

By: Christopher_Laird


Best Financial Markets Analysis ArticleSynthetic Dollar Short - Richard Russell and other gold writers talked about a ‘synthetic dollar short' based on debt in 04/5. The thesis is that overly indebted entities will face a day when their loans are called in, and the demand for dollars will rise dramatically, as assets are liquidated to pay off positions/debt.

The often discussed Yen carry trade has a similar mechanism, where lots of Yen have been borrowed for the last 10 years and invested in various markets that yield more than the half percent Japanese interest rates. Big and small investors have taken advantage of this more or less free money, riding the interest rate bonus with little risk – up to now.

For example, a person can borrow Yen at about 1%, then change that into USD and put it in US treasuries which offered, say, 5% until just recently. They get a free 4%. Combine that with more leverage, as hedge funds do, and they can get a lot more.

Now, combine both of these situations, massive debt in USD due to the credit bubble, and a massive and leveraged Yen carry trade, and you have a debt unwinding time bomb. Obviously it has to unwind at some point, it's just natural. You can't go on increasing debt forever, so obviously, at some point the credit bubble world wide in USD and Yen (and other currencies) will simply reverse growing – ie unwind. That means all the markets that debt is in will also unwind by force. Unfortunately for every world financial market, this process has only just begun, and the central banks are desperately trying to fend it off, to little avail. Probably their main weapon is lowering interest rates, which merely delays, but does not stop the process once begun in earnest. 

The US Fed appears to have lost the chance to head off this unwinding, being behind lowering rates by roughly 1% since August. They are cutting too little too late. The latest ¾ percent cut will also be seen to be too little too late.

Now, both the synthetic dollar short, and the Yen carry trade will ultimately have to be unwound, which is rather dangerous for all the markets they are in. I read one bankers comment that ‘the credit unwinding will not be denied', and that is exactly what appears to be happening, with rather scary consequences for all parties involved. Central banks in one way or another have infused about $2 trillion into financial institutions and markets since August according to my calculations. (The FHLB alone has loaned out $750 billion to banks in the US and such, and Citi alone ‘gobbled' $95 billion of that! Add the other $1 trillion central banks have admitted adding and you get about $2 trillion so far, which shows how really really bad things are.)

Some people might think this ‘synthetic dollar short' is just some analyst's pipe dream. Have we seen any indication that this thing is real?

Yes, absolutely. In the recent credit crisis since August 07, we saw several vicious manifestations of a rising USD and banks and institutions calling in hundreds of billions in loans to each other and not rolling over paper (commercial paper market) then having to raise hundreds of billions of dollars and hoarding it because they could not rely on the CP markets to carry their short term credit used in normal business. The USD rallied back then during this situation as financial institutions and even normal non financial companies had to raise and hoard cash as their short term credit facilities were not available. We are also now seeing the same phenomenon.

We also saw the Yen rise during this process, as Yen carry was unwound at the same time as markets were crashing, and people rushed to cash out, and sell positions and pay off their Yen carry loans.

We are seeing the same situation this and last week, as again financial markets sell off. Both the Yen rose and the USD rose dramatically. The only thing that stemmed the USD rise over 77 on the USDX this week was the ¾% Fed cut. But, as I look, the USD shows signs of rising again, even after that, already Tuesday night…We will see how that develops.

Why does this matter to us?

This certainly should matter. In recent months, we have talked about the fact that falling global demand will cause commodities in general to fall. Prices are set at the margins of any market. So even a 1% drop in actual industrial demand can cause speculators to sell their positions, and amplify any price swings. We have seen this with oil recently, as it barely got over $100 a barrel, then began a fairly persistent decline to now below $90. This, in spite of the fairly typical oil supply problems, in recent days the case was Mexico's problems, among the other usual suspects.

We have written to subscribers about this issue for months, that the general commodity complex (partly sans gold) was due for price declines. Yes, everyone was talking about inflation, and that is always a problem and risk. But the only beneficiary of the inflation that exists at this point appears to be gold. In every gold decline since 07, we have seen rapid recoveries. Every other market is down from 07 highs pretty much.

Flight to cash is the reason gold holds up despite its down drafts

But, that actually makes sense too. As we said, the unwinding of the synthetic USD short, and Yen carry trade is a flight to cash in essence. That causes both currencies to rise. Well, gold is cash par excellence. So, in this kind of situation, of a massive leverage unwinding, and desperation for cash (example banks hoarding cash CBs are lending them) and investment banks and other banks desperately raising capital, gold being cash par excellence should also be a beneficiary – just from a theoretical money viewpoint.

Frankly, what all this debt unwinding means is that cash becomes in great demand, currencies rise, markets unwind. Given the incredible leverage out there still, people ought to realize that there is a lot further markets have to fall.

Gold (precious metals) has suffered in the initial phases of these market crashes, but also shown its ability to rapidly recover, even to new heights. Pretty much no other market I am aware of is doing this, except possibly quality sovereign bonds. Basically, other financial markets are all down from their highs in 07, and 08 is just turning out to be worse. Markets are down 20% in many cases from 07 highs.

We have yet to update our alert chart on our main page, but recently we have alerted subscribers to gold's recent price corrective phase about several days before it happened. We also have discussed the fact that we expected the USD to begin a rising trend just about the time it bottomed in the 74 range. We had many reasons for that view, one of which was dollar hoarding during the credit crisis, which is still happening. We also put out an alert Sunday at about 11 am Central in that NL that we expected a further big world financial sell off, which promptly occurred Sunday night in the Asian markets.

By Christopher Laird

Copyright © 2008 Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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