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Japanese Yen Forecast - The Yen Carry Trade: Global Removal of Liquidity and Deflation

Currencies / Japanese Yen Mar 11, 2007 - 08:55 AM GMT

By: Francois_Soto

Currencies How does the carry trade work?
It's actually very simple. Here is a fictive example from Wikipedia depicting the process:

Bank ABC is borrowing X billions of Yen at 0.0% interest rate in Japan.
Bank ABC is converting X billions of Yen in $USD.
Bank ABC is investing the amount of $USD at 4.5% interest rate in USA with 10x leverage.
Bank ABC profit is (4.5%-0.0%) * 10 = 45.0%

Seems too good to be true! What is the catch?
If the Yen appreciates in value vs. the $USD, Bank ABC may lose a significant amount of money.


So is the Yen going to appreciate then?
As Japan is recovering from deflation, the BOJ might get to start raising the interest rates. Raising the interest rates is adding more pressure for the currency to appreciate.

The last economic data does not favor an increase of interest rate by the BOJ!
Yes but the Bank of Japan doesn't even have to start increasing the interest rate for the carry trade to fall apart. The carry trade is also a very large psychological game in the sense it is self sustaining due to the behaviour of market participants.

As long as traders and banks keep shorting the Yen and depreciating its value, the carry trade is still going to live. It will only take one large player to panic that everyone will rush at the exit and buy Yen before losses become unbearable.

Can this psychological game be described technically with the chart of the Yen?
Absolutely. Take a look at the Japanese Yen chart below. You will notice a very large triangle that began in 1995 up to today. This triangle represents the battle between longs and shorts in a Japanese deflationnary environment with decreasing volatility overtime.



Yes I notice this. What about the Elliott Wave Count?
The Yen now completed secondary (E) of primary [E] of cycle IV since the middle of February 2007. The Yen is now ready to appreciate significantly and exit the triangle. Over the last weeks, we can feel that market participants are getting more nervous regarding the Yen and we believe the panic should ensue very soon. We can expect the Yen to appreciate at the very minimum to its high of 120 made in 1995.

What would happen then?
Market participants who participated in the carry trade will get burned after playing with this fire for so long. By rushing to the exit, the losses will amplify and it would not be surprising to see financial institutions and banks go bankrupt like LTMC in 1998.

Moreover, it may be the beginning of the end for the extremely large credit bubble that fueled all the bubbles we encountered in the last decade: notably the tech bubble, the housing bubble, the commodity bubble and the emerging countries bubble. Why? Because it is estimated the carry trade added more than $1 trillion of liquidity in the world markets.

Does it mean deflation is around the corner?
Yes possibly. The global markets are going to fall in the case of a potential deflationary environment as liquidity is getting removed. This would be a reverse to the mean situation and the burst of a large scale and unmatched credit bubble. We are gradually moving from an expansion to preservation of capital environment.

The social mood is shifting to fear. Creditors are becoming fearful. We can feel this just with the recent sub prime mortgage issue in the United States. Banks and other financial institutions are making it harder to borrow money for mortgage.

This contagion may eventually touch companies to finally attain the consumers. The deflation would then cause the $USD to spiral down to uncharted territories. However it still too early to declare something like this would occur but the scenario is here to get prepared if it would happen.

Are bonds going to be safe in this scenario?
The credit crunch is usually starting with junk debt and climbing up to quality debt. In the short term, this means flight to quality bonds but quality bonds would fall in the long term as even government bonds may default. For the moment, we are seeing more of that flight to quality phenomenom and issues with junk debt.

What about gold?
Gold price is expected to fall in a fiat money deflationary environment because it may not be recognized as a method of payment until some point in the future and because gold holders will have to sell their gold to meet financial obligations. In our current system gold is an instrument to protect from inflation but not deflation.

Beware!

By Francois Soto, President
EMphase Finance
www.emfin.com

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EMphase Finance strives to become one of the most important website in North America concerning fundamental analysis using traditionnal quantitative and technical analysis based on the Elliott Wave Principle. The website will contain detailed analysises concerning specific companies, commodities and indexes along with educational content.


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Comments

gables
30 Dec 08, 01:46
Yen / usd

why the yen remain so strong and the economy in japan is

so weak......?

are speculators the reason ?

Thank You


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