The Yen Scary Trade

Over the dull roar coming from the markets in the past few weeks, you may have heard some murmuring about the yen carry trade. The yen carry trade sounds more confusing than it actually is.

Broken down to its simplest terms: speculators borrow yen at very low interest rates and trade for other currencies yielding at higher interest rates…and then capture the difference between the two. This works well for speculators – until something goes awry. And…hmmm…we can think of a few situations in the markets that haven’t gone according to plan lately.

“For several years, the yen-carry trade has nurtured and facilitated risk-taking throughout the world’s financial markets,” writes The Rude Awakening’s Eric Fry in today’s guest essay.

“It has provided a seductive source of low-cost liquidity that has emboldened speculators to borrow yen at dirt-cheap rates of interest and invest the proceeds in higher-yielding investments. As long as the ‘higher-yielding investments’ obliged with high-yields, the process worked beautifully. And it had been working very beautifully…until about four weeks ago.

“But now that stocks and bonds become very volatile – or simply falling – many carry trades are producing losses. As the losses mount, the pain is increasing. As the pain increases, the speculators begin to sell their ‘high-yield’ assets and repay their borrowed yen.”

Eric J. Fry
August 31, 2007

Does this mean you should steer clear of yen? Not on your life. Keep reading today’s guest essay to find out why:

The Yen Scary Trade

Over to Short Fuse, reporting from Los Angeles…


Views from the Fuse:

*** Earlier today, both Bush and Bernanke gave speeches on the subprime crisis/credit crunch.

Addison, over at The 5 Min Forecast reports:

“George W. Bush is expected to propose multiple initiatives to bail out troubled homeowners in a statement today.  The president will outline reforms that will help keep subprime and struggling borrowers in their homes – and keep Fannie Mae in business.

“No one really knows how he will pull this off. Least of all, him. But you can bet your last yuan the proposal will be audacious and its funding will come at your expense… capital for refinanced, bail-out-rate loans doesn’t grow on trees. But it does get printed in dollars.”

As for Bernanke…in his speech, the Fed chief assured the nation that the Federal Reserve will “act as needed” to keep the credit crisis from hurting the national economy…but as to not get anyone’s hopes up too high, he said this:

“It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions,” Bernanke said.

“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”

Everyone turn to page 374 in their Deciphering Fedspeak manual…

*** And new data released by the Mortgage Bankers Association shows that subprime borrowers aren’t the only ones defaulting on loans…

Properties owned by speculators in previously ‘hot’ markets, such as Florida, California, Nevada and Arizona, account for a higher percentage of defaults than the national average.

These home flippers were gambling that home prices would just keep going up and up – and that there would still be buyers around wanting to pay those inflated prices.

Unfortunately for them – and for you, if you happen to live in a neighborhood where prices were driven up by speculation – that’s not the case. And as these houses sit empty, you can bet the price of your house is being pulled down.

*** Remember the Tortilla Crisis in Mexico, caused by the increase in prices of corn? Well, now in Italy comes the Pasta Protests…

As demand for grain grows, due to nervous speculators and our favorite biofuel fraud, so has the price…and in Italy, the price of their main staple has gone up 25%.

So, on September 13, Italians are putting down their cutlery and abstaining from a day of tortellini, ravioli, and the like to protest this price hike.

They may have to do more than that to make an impact though…in Chicago, wheat futures headed for the highest monthly gain in 34 years, today.

“This is astounding, even to me,” our commodities guru Kevin Kerr excitedly told us this morning.

“Since I added the March 2008 Wheat 860 calls in Resource Trader Alert on Monday at 30 1/2 it has surged higher every day. Today is no exception.  Overnight wheat is up another 20 cents for yet another record. The wheat option is now offered at 58 1/4 – that’s pre-open.

“If we were to sell here right now that would be 90% profit in 5 days.”

We’ve talked quite a bit about ‘fat tails’ in these pages…about events that lie so far outside the normal course of events that we tend to push them equally far away in our consciousness, events that are so devastating that when they do occur they cancel out every other consideration. There may be only a very slim chance that the human race will be wiped off the face of the earth, it is true. But it would probably pay us to take that slim chance very seriously.

Still, just because a fat-tail disaster might smack us in the face at any moment, does that mean we are in favor of more, say, government regulations on food production?

Here, we are forced to hem and haw. Government regulation tends to be ineffective in many cases. And since regulators are frequently drawn from the same industries they are supposed to be regulating, we think they tend to be counterproductive in all the others.

So, we are neither prescribing policy nor proscribing it. We are merely grumbling in our curmudgeonly way that we liked the old genetically unmodified world better. We have no desire to eat strawberries armed against frostbite with herring genes or cauliflower with an IQ higher than ours. We like our food au naturel, unrefurbished, unhedged, and in default drive. Unless it is communion wine, any transformations of nature need to pass the smell test first. We need to be protected from them, as surely as we need to be protected from bad checks, assault, murder, and another Michael Jackson trial.

You see our problem, dear reader? We would like the state to stop telling us what to do-whether it is in airports, in our schools, or in our bedrooms-but we dig in our heels equally at efforts by global corporations to improve our water, our potatoes, or our boeuf bourguignon at the expense of our local culture and with subsidies from our tax dollars.

This is unlikely to win us any popularity contests today when there are only two acceptable positions on globalization: It is A Very Good Thing. Or, it is A Very Bad Thing. But slogans don’t always do the trick. Each problem has to be thought through in its own terms. Not only is globalization neither entirely good nor entirely bad, it is not even one single thing. It is several. It is about free trade and costly subsidies, about gourmet water and junk food, about hard capital and soft drinks-all of which have their own reasons for being and their own consequences, and all of which are mislabeled, poorly understood, and constantly confused. In fact, the only thing you can be sure of about globalization is that it provokes extremes of two emotions in the mob-greed and fear. In other words, the only thing that is certain about it is that it is a public spectacle.

Naturally, like all public spectacles, globalization is wrapped up in a huge amount of cant. For instance, if you are a poor country, you are supposed to take to the thing as eagerly as a diabetic to insulin.

Now, if it was just a matter of freeing up trade between countries, we would nod our heads in agreement. The exchange of goods and services between people is, and always has been, a good thing. It is, so far as we can see, a far better way of getting what you want than hitting your fellow man over the head. But for it to really work, trade-like driving-needs a set of rules everyone follows; otherwise you are liable to crash or be run over.

And this is where it gets complicated. Because it turns out that many of the rules of global trade are set by the very people who are weighing down the market with all sorts of subsidies, sweetheart deals, perks, pork, and privileges, in the first place.

Take the World Bank, which is in the business of telling countries what they need to do to play the global trade game. In the lumpen imagination, the World Bank is not too different from the local neighborhood savings and loan-a kind of multicultural version of the friendly bank in It’s a Wonderful Life. But the real World Bank is headed up not by Jimmy Stewart but by people like Paul Wolfowitz, a man whom his best friend wouldn’t call a soft touch. Confirmed as the bank’s boss in 2005, Wolfowitz immediately proclaimed he was on a mission of mercy:

“Helping the poorest of the world to lift themselves out of poverty is a noble mission or, as former Secretary of State George Shultz said, ‘a beautiful mission.’ “

But, the Sisters of Charity do not have to worry about the competition. Wolfowitz has been one of Washington’s biggest hawks, ever since the days when he argued for the use of tactical nuclear weapons in Europe. To this day, he likes to praise Indonesia’s Suharto, who in his 32-year reign looted $30 billion from the public treasury and turned his country into one of the most corrupt in the world. Of course, on second thought, that might be the perfect resume for the Bank. After all, the World Bank has a bit of a track record when it comes to getting and spending, not to mention laying waste.

We put before you two countries:

Both are Asian. One has little land, most of it eroded hillsides. Its population density, already the highest in the world, is exacerbated by heavy immigration. It has to import all its raw materials, water, and oil. It receives no foreign aid whatsoever and until recently was still a Western colony. It has an authoritarian government.

The other is also densely populated, but it has lots of arable land and natural resources. Free from colonial rule, it has also been the recipient of about $55 billion in aid over the past 40 years. It is a functioning democracy and the World Bank’s pet project.

Which do you bet would be better off? It seems to be a no-brainer – the second one, of course.

But wait-the country without resources is Hong Kong, today routinely at the top of lists of the best Asian cities in which to live and do business; and the well-endowed one is India, after 60 years of independence still one of the poorest countries in the world.

“The standard of living in Hong Kong had multiplied more than tenfold in forty years, while the standard of living in Calcutta has improved hardly at all,” says John Templeton.

After nearly half a century of centrally planned economic development, India’s annual per capita income remains somewhere between $500 and $3,400 a year, depending on the type of calculation you use and whom you are talking to.

A per capita income of around $750 puts India-the fourth largest economy in the world-in the company of sub-Saharan Africa. Meanwhile, Hong Kong has a per capita income of over $20,000 a year, on par with first world countries.

What on earth is wrong here?

Lila Rajiva [with Bill Bonner]
The Daily Reckoning

P.S. If you can’t wait until tomorrow for more of our hemming and hawing, you can get your fill in our latest book, written with co-author Lila Rajiva:

Mobs, Messiahs, and Markets

The Daily Reckoning