Jump on Board the Global Capital Stampede to the Japanese Yen
Currencies / Japanese Yen Nov 09, 2008 - 12:34 PM
Jack Crooks writes: Last year I dedicated several Money and Markets columns solely to my expectations for the Japanese yen carry trade to unwind. But since that trend took a breather in the middle of this year, I haven't been keeping you up to speed.
Let me get you caught up today.
The Yen-Carry Trade …
If you're wondering what the heck the yen-carry trade is, let me grab the brief explanation I used in my August 24, 2007 column …
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.
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 euro or Hungarian forint), and then used the proceeds to place their big bets.
Right after that column was published, the Japanese yen shot up by roughly 22% over the next five-and-a-half months. And today, I think that even greater profits lie just over the horizon.
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| In just 5½ months, the Japanese yen gained an impressive 22%. |
To back up my forecast, understanding the flow of global capital is key.
Global Demand and Global Credit …
I can say with nearly 100% certainty that the theory regarding U.S. decoupling has been completely discredited … at least in this global economic cycle.
No longer do the “bright lights” of the financial media believe that the world's economy can sustain healthy growth when the U.S. economy is cut out of the picture.
I credited a lot of the currency market's price action to the widespread, “consensus belief” that the global economy would be fine as the U.S. puttered out. Yet I was never comfortable ruling out the significance of the United States' $14 TRILLION economy.
My two key reasons:
#1: Dysfunctional Credit Markets Spread Far and Wide
We all know how subprime mortgage-backed securities got the ball rolling for lending in the United States. Now scores of major banks and institutions have either gone belly-up or are currently suffering through tough times.
And in the last few months we've realized just how heavily exposed the rest of the world has become. Not only to bad debts connected to the U.S., but from various other non-performing loans made throughout the globe.
That brings me to my second key reason …
#2: The Biggest Over-Exposure to Bad Debts And Bad Decisions Lies OUTSIDE the U.S.
There's no doubt the subprime/lending crisis is having an adverse effect on the U.S. economy. But when you look at the big picture, the heaviest exposure to vulnerable loans and bad debt exists elsewhere, i.e. outside the United States.
In last Saturday's Money and Markets I talked specifically about how Western Europe and the United Kingdom were heavily exposed to loans made to emerging market economies.
Basically, Europe has bought into the export-centric model of these economies. And now that developed economies are slowing significantly in the face of standstill credit, the export-centric economies are bound to default on loans.
That means Europe's humongous exposure and the myriad of writedowns are going to hurt the underlying currency.
To put this in perspective, European banks' exposure to emerging market loans is roughly six times as large as the United States' exposure to subprime mortgage-backed securities.
What's more, the exposure of the American and Japanese banks to these emerging, export-based economies is minuscule compared to where the super-active European banks sit.
But now you're wondering, how does this come back to the yen-carry trade?
Simple …
Japanese Yen Performance is Centered Largely on Capital Flow
The fact that so many recent assumptions regarding the global economy are now getting dumped on their head means global capital is going to reverse course and return to where it came from.
This dynamic — one of deleveraging and risk-aversion — is what's buoying the U.S. dollar. And it's something that I believe will stick around for quite some time and continue to support a bullish view of the buck.
But it's not only the buck that benefits in this scenario …
Just as so many developed and emerging nations borrowed cheap U.S. dollars to fund growth … they also borrowed cheap Japanese yen.
And now that the currency markets are adjusting to reflect the shifting global economy, many are rushing to repay the loans they've taken out in Japanese yen.
This is a significant trend of unwinding carry trades. And it means a significant appreciation is just around the corner.
Take a look at this chart to get an idea of where the Japanese yen currently stands …
The yen has shown a considerable appreciation that corresponded with U.S. dollar strength. The red box on the chart highlights that period.
Recently, however, the yen has put in a sharp pullback. I am not surprised. I've been expecting a U.S. dollar correction.
And naturally, since the yen has been moving closely with the buck, seeing a correction like this in the yen is no big deal.
Except … when you consider the whale of a buying opportunity it's offering up.
There's nothing to say the yen can't go lower here. But if I'm right about the severity of the global financial crisis and economic deterioration, then the Japanese yen — just like the U.S. dollar — is in for a fast and furious ride … upwards!
Best wishes,
Jack
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