Vigilant Investor

We’ve long worried about what will happen to the dollar and U.S. rates when the Yen Carry Trade is forced to be scaled back. When you borrow in the Yen as so many have to take advantage of the BOJ’s below market rate loans, and then convert into other currencies for investing, you’re certainly planning on a few assumptions. First, you don’t want the Yen to gain in strength, otherwise you’re cost to convert back and pay off your loan will erode your investment return in the other currency. Of course, when you initially converted into your new currency, you invested that money to get a decent rate of return. Initially conservative investments were the norm — borrowing for example yen at .25% a while back and investing in U.S. Treasuries at 5.0% — not a bad transaction, especially if you’re leveraged up 10 or 15 times.

However, all bets were not so conservative — especially in this era of newfangled alchemy finance, where junk rated debt was converted into CMO / CDO packages with AAA ratings from the major ratings agencies. Yes, those would be the same agencies with egg on their face in the wake of the Bear Stearns debacle unfolding. Their AAA ratings are now going out the window as various debt derivatives are being marked to market at 50 to 80 cents on the dollar, vs. marked to (computer) model, the later having justified unrealistic pricing despite there not being a tested liquid market for the assets or considering the consequences of a disorderly liquidation and valuation at market.

Granted, those models were not made by idiots — as Long Term Capital Management (LTCM) proved, even geniuses can operate in a dangerous vacuum of historic tendencies and averages. In our present environment, those models assumed the average environment over longer periods of time when measuring the risk associated with the ratings they were giving, failing to recognize as we do nearly every day here at Vigilant Investor –that, yes, now is different. We are in the midst of a giant money supply induced credit bubble that is nearing some tipping points, and perhaps some major ones, and at least some very inflationary ones for dollar holders.

Other evidence slowly comes to the surface that global central banks are nearing their limit for dollar inflation and that dollar support is waning. Already Kuwait and Syria have de-pegged their currencies from the dollar. By doing so, they’ve finally allowed their own citizens to keep the purchasing power that is rightly theirs in their own currency as dollar holders dump dollars for oil by the $ hundreds of millions. That translates into the eventual selling of dollars and the buying of local currency for any trade partner — unless, of course, that nation decides to inflate its own currency in order to keep itd goods priced cheaply in dollars. But, as noted, that’s no different than stealing purchasing power from the local currency and handing it to dollar users. Moreover, it is very inflationary in local currency terms.

So, with Kuwait and Syria leading the pack, it appears more players are delicately testing the waters. Egypt has announced that it is reducing its U.S. dollar holdings as it follows other Middle Eastern countries in diversifying its $27 billion in foreign currency reserves, the country’s Investment Minister Mahmoud Mohieldin said in London, according to Bloomberg on June 26. Said Mohieldin, “Some countries in the region, including Egypt, are diversifying their reserves away from the dollar…I think economic concerns over the U.S. are pushing more and more towards diversification.”

Meanwhile Rueters reports the UAE is considering dropping its currency peg to the dollar, but only with other GCC nations, per Sultan Nasser Al-Suweidi.

In Moscow, Russia’s central bank guided the rouble about0.5% higher on Tuesday vs. a basked of two currencies (0.55 dollar / 0.45 Euro) with the aim of keeping inflation within its annual target guidelines.

But we started off the post talking about the carry trade. The pressure is now on: European carry trade players have started to back off their trades, and the Yen has responded by gaining against the Euro and the dollar as those investors convert out of both and buy back the Yen.  Supply and demand 101, folks.

Now where that gets hairy is with the U.S. dollar related Yen Carry trades.  The Yen is getting stronger - - and when models, however sophisticated they are, get stressed in unexpected ways, hands get forced to clean up leveraged plays. We’ve seen that already in the Bear Stearns situation, where the hedge funds that are in dire straits used 10x and 15x leverage on investor assets. Management’s inability to predict the value of the debt instruments the bought with that leverage has caused and implosion rippling through the markets, even taking down small broker dealers.  We saw this also with LTCM in 1998 where its managing Nobel Prize winning Ph.D.s were exposed with 35x leverage.

Now imagine a hedge fund doing the same using that is ALSO dependent on the Yen carry trade.

In the world of hedge funds and cheap, freshly “invented from nothing” credit — well, who knows where the next Bear Stearns-like victim is lurking. After all, we didn’t know it’d be Bear Stearns. We could only hypothesize that such ginned up credit supply would cause someone to overextend with leverage, and that it’d likely be tied to the sub prime market given how loose money supply created one of the most reckless lending environments in history.

Its been said time and again that ginning-up money supply is like spiking the punch bowl time and again. And with that as a backdrop, the shaky dollar and macro fundamental structure is readying to slap more players into sobriety. The hangover will not be pretty as more dominoes fall.

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