Unwinding the Carry Trade

Good day… And a Happy Friday to one and all! It’s been over two months since I’ve been able to say that to all you dear readers… So, let’s make this a Fabulous Friday! In case anyone hadn’t noticed, I’ve given an upbeat name to each day of the week. I think that being told you have cancer by a doctor makes you think about things in a different light!

Whew! What a day in the markets! The Dow was down over 300 points and then rallied at the end of the day to close down only 15 points! WOW! And how about that Japanese yen (JPY)? A three-whole-yen move in one day! Shoot! The past year or so, we would have been happy to see a positive move in yen in any amount! But, that’s the markets for you… Just when you think it’s safe to go back in the water!

Yesterday, I said that I needed to see more evidence that the “carry trade” was indeed unwinding. But I think I’ve seen enough! The high-yielders are getting the stuffing knocked out of them, and the low yielders like yen and Swiss francs (CHF) are gaining ground. I know, I know, a lot of you are saying that I couldn’t see the trees in the forest, if I hadn’t seen this before now… That’s OK… At least I see it now!

What does this mean? Well… It means that the high yielding currencies – kiwi (NZD) and krona (SEK) come to mind are not going to see the light of day for a while. However, low yielding currencies like yen and Swiss francs are going to be the belles of the ball for a while.

I’ve warned people about this for over a year now. And I was beginning to look like the boy who cried wolf… But here it is… Right here in front of us, staring us right between the eyes.

But – as I asked yesterday – why is the euro getting caught up in this? It’s not a high yielder. As I read in The Daily Reckoning yesterday, Bill Bonner said it best regarding the euro sell off…

“People have fewer euro-denominated debts than dollar-denominated debts, so the dollar rises against the euro. On the other hand, speculators in the carry trade have huge yen debts. They borrowed at low yen rates in order to buy higher-yielding investments – including subprime CDOs. Now, they’ve got to sell their dollar positions and buy yen in order to repay their yen loans. So the yen rises against the dollar.”

Yes… I know, I’ve explained this to readers for years now. The “cross-trades”… Where the main activity could be buying yen versus kiwi, eventually we’ll see selling of euros on all the cross-trades that exist.

The good news for the euro on Thursday was that the selling ended very abruptly and at the end of the day the single unit was seen rallying back versus the dollar.

Well… There were rumors going ’round, someone’s underground. No wait… The rumors yesterday were that the there was an emergency Fed meeting in the afternoon. Doesn’t this remind you of 1998, and the LTCM meltdown? Strange things. I was at home writing the Pfennig in 1998 when the LTCM meltdown occurred, just like I’m at home writing the Pfennig during this meltdown!

(For those of you with enquiring minds… I was “retired” in 1998, and wrote from home each day, with my little buddy Alex on my lap most days. Then the Big Boss, Frank Trotter and I would work on starting EverBank!)

My good friends, the Aden sisters – Pam and Mary Anne – sent a note to their readers last night… And here’s a snippet of that letter.

“The sell off in stocks spread to the precious metals, industrial metals, energy and agriculture markets. Global liquidation of all markets is happening regardless of the market trend. Commercial paper and the T-bill rate collapsed causing vulnerability in the normally conservative money market funds. No region of the world escaped the trouble, and a financial crisis similar to the July to October 1998 or October 1987 period is happening.

“This meltdown has shaken the market hard and most of our positions are affected. Today could possibly be the worst intensity day but we could see more whips upcoming. By the end of today some calm returned to the market. The financial markets took the lead in a late day rally to close up, but it’s still to be seen if the worst is over.

The least affected of our positions are the energy stocks and the oil price remains strong above $70. Gold has also held up well considering, as it’s well above the June 27 low, and the major trend remains up. The euro, British pound and Swiss franc are firm. The yen carry trade currencies are the most affected.”

I have worked with the Aden sisters for over 15 years!

OK… The Australian dollar (AUD) is on the cusp of a “high yielder”. Some would consider it a high yielding currency, and therefore it would get caught up in the unwinding of the carry trade. There were rumors going around yesterday that the Reserve Bank of Australia was in buying the currency to stop the bleeding. It makes sense, given the rebound of the Aussie dollar as the day ended.

Unfortunately… We’re seeing more selling overnight. So… Batten down the hatches!

So… Carpe di-yen! I had a trader friend mutter those words to me yesterday… And it cracked me up! But hey! It makes sense, right! Seize the yen! The currency is going to close out its best week of trading versus the dollar since 1998! Of course for a lot of investors that didn’t own yen before, buying it right now might be a bit scary. But for all of you, like me, that have suffered with yen positions… Carpe di-yen!

The Housing market received some more bad news yesterday when it was announced that new homes slid to the slowest pace in more than 10 years in July! OUCH! Now, that’s going to leave a mark! The 6.1% decline in new homes wasn’t the only dose of bad medicine for housing. The housing sector also had to swallow the news that building permits also were circling the bowl.

And I would be remiss if I didn’t mention something that I saw yesterday that scared me at first, and that is… The news that Countrywide Financial Corp, the largest mortgage lender in the United States, had to draw down their entire $11.5 billion credit facility. I think this was the straw to stir the stock markets meltdown in the first part of the day yesterday.

The thing to think about here is simply that they drew it down. It didn’t say they needed to use it, and therefore they had no other avenue to finance operations. No… It didn’t say that, so the news wasn’t so scary after all… But still… Noteworthy, eh?

One more thing… Yesterday I talked about Treasury Secretary Paulson, and his claim that all this wouldn’t lead to a recession for the United States and of course I had to take the opposite side of that claim. Shoot Rudy, the stock market is causing the sales of Alka-Seltzer to soar, the housing market is falling into an abyss, and credit… Yes, credit… The lifeblood of the economy we now have is drying up… Uh-Oh… So… Henry! Put that in your pipe and smoke it!

Before I go to the Big Finish… I want to make sure that people understand that I truly believe that once this liquidity/credit crunch passes… And we get to the fall, and still the housing meltdown is occurring, that the Fed would step in, and reduce rates… And when they do. The dollar will get hammered once again.

Currencies today: A$ .7850, kiwi .6740, C$ .93, euro 1.34, sterling 1.9810, Swiss .8225, ISK 69.10, rand 7.4750, krone 5.97, SEK 6.97, forint 194, zloty 2.8525, koruna 20.54, yen 113, baht 33.40, sing 1.5370, HKD 7.81, INR 41.37, China 7.5975, pesos 11.22, (no dollar index), Silver $11.70, and Gold… $662

That’s it for today… The 100-degree days finally broke yesterday, and I was able to sit outside and listen to my beloved Cardinals. They head to Chicago today for a weekend series… If I wasn’t dragging a cane around with me, and walking as slow as Tutor Turtle, I would be tempted to head up to Chi-town. That environment ought to be crazy! It’s crazy any time these two teams get together for a weekend series, but this time both of them are in a pennant race! If you’re going… BE CAREFUL! The last weekend of summer vacation for my little buddy, Alex… He starts middle school next week! So… I hope you enjoy your weekend… Have Fabulous Friday and weekend!

Chuck Butler
August 17, 2007

The Daily Reckoning