Riske Business May 2007

SHHHHHH!!......I’m waiting for the other shoe to drop. The first shoe, the ugly subprime mortgage collapse, was the first to drop. The drop has been so loud there’s no need to talk more about it. The second shoe is just now coming off and has a ways to drop, but when it does it’ll be loud in a different way. That second shoe is the so-called “carry trade” and its unwinding.

carry trade was made possible when Japan’s central bank took a typical reaction to a stock market crash and created lots of new yen while lowering interest rates to zero. Smart, big money went in to Japan’s markets, borrowed vast sums of cheap and plentiful Japanese yen, then promptly bought American bonds returning more than 5%, New Zealand bonds earning more than 7%, etc. In other words, borrowing Japanese yen and buying other countries’ bonds carries the trade, thus the term “carry trade”.

The carry trade has been extremely profitable, while involving little or no risk, for several years. In the past few years it has grown as fast as the formation of new hedge funds. Imagine for a moment that you have formed a hedge fund with $10 billion to invest. You immediately borrow $2 billion yen because of your handsome balance sheet and use the money to buy $2 billion worth of 7 1/2% New Zealand bonds. Today’s yen rate is 1/2%, so the net is 7% without using any of your investable funds. 7% simple interest income in one year on $2 billion comes to a cool $140 million. As the hedge fund manager, you have just made $28 million each year on this trade alone.

Since the beginning of this carry trade, two components have been changing. The first is a slow recovery of interest rates by Japan’s central bank. Japanese fed funds rate remained at zero for years while the Japanese frantically tried to boost Japan’s economy out of deflation, the rate has had two quarter point increases and it now rests at 1/2%. This trend to higher rates will persist. The second insidious fundamental is the ongoing loss in purchasing power of the US dollar. This trend will also persist for reasons we’ve mentioned in past columns.

The United States government has decided to go on deficit spending even though foreign nations now hold more than $2 trillion worth of its debt. The U.S. must now borrow or print $3 billion in fresh new money each day as it continues its “guns and butter” economy. America’s trading partners want to continue shipping goods to the U.S. and they’re (so far) willing to lend us the money. The Southeast Asians are loathe to stop but they are beginning to want to hedge their bets by diversifying into other currencies and precious metals. Currencies like the U.S. dollar are governed by the same economic fundamentals as commodities; i.e. the greater the supply, the cheaper the product. Thus, if you are earning 5.5% on your money but the value of this money is declining by 6% the net is a loss. Keep in mind that as liquidity dries up the Fed would reduce interest rates which would further speed the unwinding.

These twin pincers, higher yen interest rates and depreciating U.S. currency, are causing the hedge funds to reduce their exposure to this carry trade, thus the “unwinding” of these trades is beginning. If this is correct and the carry trade continues to unwind, what do we expect will happen?

First, we cannot estimate for you how much yen is involved or the size of purchases of U.S. and other country bonds (corporates too?). There are now more than 8,000 hedge funds and we think it would be safe to assume most, if not all, are involved in the carry trade just because the income is so sure and easy. So, if 8,000 hedge funds each have an average of $500 million worth of carry trade that would amount to $4 trillion worth of bond holdings around the world. Switzerland’s low rates have made it a part of the carry trade too, but to a lesser degree because as far as we know the Swiss have not been printing money nearly as much as Japan, so we are guessing the Japanese have much more out there, say USD$3.5 trillion worth.

Imagine now that you are a Japanese citizen and all of a sudden the carry trade begins to unwind in earnest. Within a period of, say 3 years, nearly $2 trillion worth of money returns home to the banks. What would happen? Well, first the Japanese banks would be looking at any warm blooded individual to borrow money and put it to work, kind of what’s just happened in the housing industry here in the U.S. Second, Japanese banks are the biggest stockholders in Japanese equities so one would expect them to inject hundreds of billions into stocks, especially Japanese stocks.

Japanese households keep 51% of their savings or $2 trillion in the Japanese Postal savings accounts, so there is still a lot of money waiting to be invested within Japan itself. The Japanese are still afraid of the stock market, but the Nikkei crash was almost 17 years ago so the long bear in Japanese stocks could finally be coming to an end.

What could happen on the other side? During the 1980 to 1990 Japanese asset boom, the best performing assets according to Dr. Marc Faber were Taiwanese, Japanese and Korean stocks and Japanese and Taiwanese real estate. The worst performing assets were Middle Eastern and Latin American stock markets (following the 1981 Petrodollar crisis), commodities, Texas banks, oil servicing and mining companies. Also, with hundreds of billions worth of U.S. Treasury bonds coming home, one might expect the Fed to print enough money to be able to buy them back while interest rates on long bonds trend upward.

If you agree that the carry trade will unwind and that the unwinding may accelerate as it unwinds, then you may want to consider investing in Japanese yen via the new ETF: symbol FXY. We own JOF, the small company Japanese stock closed end fund that pays more than 6%. Also consider EWJ, ITF, JEQ, DNL, DFJ, or JSC.

Riske began his entrepreneurial career with a waterbed store in Grand Forks in 1971 called The Walrus. Walrus Waterbeds was sold to HOM Furnature in 1984. Currently Riske is owner of Take Two Video, Take 2 Express, MJ Capelli Family Hair Salons, VidCycle and Sunseekers Tanning Salon. Riske is not a licensed financial advisor and those seeking investment advice should consult with a licensed financial advisor. To contact Riske, email marty@fmbizjournal.com

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