The Pause That Refreshes

We saw a short reversal in the recovery trade that has benefited the risk currencies, especially Australia, New Zealand and the Eurozone. As of last Tuesday morning when I began this column, the risk push is back on: The euro and Kiwi are pushing new yearly highs with the Aussie hot on their heels. Poor Canada got dumped on due to its poor retail sales but will likely fall back in line.

Let’s look first at the euro. This really looks like a gasping market. It resembles all those that make higher highs on a relentless basis. And when you talk about relentless, the mighty euro sure fits the bill. Until Monday, the euro had not seen two down days in a row for the entire month. That’s remarkable.

But the real question is, does that movement arise from its own strength, or is it something else? I have long been a proponent of an impending euro disaster — and I’ve positioned my paid Master FX Options Trader readers accordingly.

The one thing that would forestall my forecast of disaster would be an intermediate recovery. Please notice two words in that previous sentence — “forestall” and “intermediate.” The euro disaster is not over — it has only been delayed. Like all excesses, it must eventually come to light and be dealt with. A foundation can only be undermined for so long before the structure it supports has to topple.

That’s what has been going on in the United States. And without a doubt, the euro problems are much, much bigger. Moreover, the European Central Bank’s remedies thus far have not been nearly as effective as they have been in the United States. But the second item of note — “intermediate” — is the type of recovery that will allow the Eurozone to gloss over their immediate problems.

Thus it looks like “business as usual” for European banks and businesses. During the boom-boom years, the systemic problems of the Eurozone were easily glossed over. If we can return to that sense of “normalcy” — and believe me, that’s what every central bank is working toward — then the euro and the U.S. dollar will continue to part ways. Mainly because the U.S. problems are all exposed and out there for everyone to see. The Eurozone has managed to weather the storm, keeping its central bank rates higher than the U.S. rates, so it has all the appearances of not needing the drastic measures that America has taken. Ipso facto, it must not be in as bad shape as its North American counterpart.

But the way things seem is not always the way they are. Everybody has to pay the piper, and what you sow is what you reap. There are NO exceptions. So when we sow thievery and oppression, crushing economies to benefit the friends of central bankers, there will be hell to pay. And I’m not just using a figure of speech.

So then, the euro has posted a new high. It doesn’t have the internal strength on its own to continue higher. But as “good” recovery-style news comes out, they keep the Ponzi going.

So what will be the real drive going forward? Let’s take a look.

The Dollar Carries On

First of all, the U.S. dollar is in danger of becoming the currency of choice for the new “carry trade.” We’ve discussed this before, but it’s worth mentioning again — especially for new readers.

Plainly put, the carry trade is when a trader borrows money in a currency with a low interest rate, then uses the proceeds to buy a currency with a higher interest rate. So even though he has to pay interest on the currency he borrowed, he’s making even more in interest with the currency he bought.

Since the interest rate difference is so small, the carry trade is only worthwhile if it involves a tremendous amount of cash. That’s why it’s generally done by the really big, big players. Here’s an example of how it works.

Say an institutional investor borrows a bunch of dollars at a .25% interest rate. Then he uses those dollars to buy, say, Australian dollars, which are paying a 2.75% interest rate. So, he’s losing .25% on the dollars he borrowed, but making 2.75% on the Australian dollars he bought. And he earns that in perpetuity. He doesn’t have to do anything. It just keeps earning money day after day.

For years this has been done with the yen, as it always had the lowest rate of interest. It helped to keep the yen very cheap, which is exactly what the Bank of Japan wanted. It hoped the cheap currency would expand their perpetually receding economy.

Now this same scheme is being done to the dollar. So far, it’s only been in “bite-sized” chunks — but only because no one is very sure if the world economy is out of the woods. Still, unless more bad news comes, this is a profitable trade.

Also, higher interest rates tend to attract more money going forward (as all the scared money comes back into the market) — so the higher-yielding currencies also appreciate against the lower-yielding ones. Therefore, the investor makes a double boon: the interest and the appreciation.

So the big institutions have an interest in depressing the dollar. Any gain in strength or interest rates threatens the easy money of the carry trade.

But, as noted, the institutional players aren’t the only ones who want to keep the dollar down.

Bad Politics = Bad Currency

As I mentioned, the Bank of Japan was all too happy to let the yen carry trade go on, since a weaker currency was seen as a way out of its economic mess. The U.S. government is essentially taking the same route. Without a doubt, it is complicit in driving the dollar lower.

Like in Japan, a cheaper currency helps service ever-increasing debt (I’m certain they have long since abandoned any prayer of paying it off). And the indebtedness is increasing at a faster rate than at any time in history. As long as the major economic power wants to see its currency cheaper, it will do whatever it takes to get that done.

By the time you read this missive, the Fed will be ending their two days of meetings to determine what to do about U.S. interest rates. If you haven’t already heard the answer, what do you think it will be? It is important to formulate an answer to that with all the evidence before you, because it will give you an added insight into how the central bank works. Here’s my answer. They will not be raising rates.

Now that, of course, is no new revelation. But what will they do looking ahead? When will they start earnestly looking at raising rates? The answer to that question lies in our own recovery.

While data appear to show that the economy might be coming out of recession, unemployment is still at multiyear highs and is not decreasing. Housing numbers are improving, but they will NOT be coming back to what they were. All the weight put on housing starts, new purchases, purchases of existing homes, new permits issued, etc., are all a smokescreen. And if not intentionally an “illusion,” it certainly will not make a difference to the economy. Here’s why…

Under the “old economy” (two years ago), a house was a store of value. We all implicitly knew that our savings were not “safe” in a bank, and if they were, they certainly were not growing to keep pace with inflation. So we invested in real estate. I don’t mean that everyone went out and bought rental properties or tried to flip houses. What I really mean is this:

If you ever refinanced your house and took “cash out,” you invested in real estate. If you ever used a home equity loan or a home equity line of credit — you invested in real estate. The unwritten assumption was that your house would continue to increase in value, even as you were using the equity. We became a nation of equity spenders. Treating our homes like ATM machines, we attempted to increase our wealth by means of a bubble market. Even if you didn’t think you understood the nature of a bubble market, implicitly, or even instinctively, you did.

Spending a house’s future earnings meant that we believed our money would be worth less in the future than it is now. We believed its value was decreasing. (Incidentally, we were right.) But we were on the “safe side of the bet.” Because we would spend valuable dollars now, but repay our bill with less valuable dollars later. This is why a 30-year mortgage in a centrally managed and inflationary economy is such a good deal. You lock in today’s price, but pay it off with increasingly inflated money. It is that very inflation that makes your house go up in “value.” Any reasonable consideration would conclude that a house is not as “valuable” after 30 years of living in it. It must depreciate, because it “wears out.” Anybody who has ever owned a home knows this to be true. Defer just a few years of maintenance, and it will soon overwhelm you. Before long, you begin to wonder if you own the house, or if the house owns you.

But in the end, when houses were all in debt up to their value, and many far more than their value, we stopped investing in real estate. Mainly because we couldn’t afford it any more. Either our payments were already too high, or our equity was too low. At any rate, when people stopped “investing,” the residential market began crashing. It will not return to what it was, and vainly hoping for more increases in housing numbers to do that will only bring to pass the old proverb, “He that sows to the wind will reap the whirlwind.” In other words, vain hope isn’t gonna save the farm.

Getting back to the moral of our story, the government, which will not control or reduce its spending, can only raise taxes, cut services or inflate the currency in order to get us out of this mess.

Of course, raising taxes or cutting services are the easiest ways for a politician to lose his or her job. So the third option is always exercised. If done properly (according to prevailing monetary theory), it will be painless, and the effects of inflation will be partially offset by the ever-popular cost of living increase. That way everyone shares in the illusion that they are “keeping up with” inflation. But that’s all it is… an illusion.

So we’re up to two entities with a vested interest in keeping the dollar down — the institutional investors who want the carry trade to continue, and the U.S. government, which needs a weak dollar to plaster over its massive debt.

And the dollar has yet another enemy…

Neither a Borrower Nor a Lender Be

It’s easy to overlook, but when you buy bonds, you’re buying debt. You are loaning the issuer your money and getting their interest rate as your profit. Corporate bonds represent the debt of individual companies. When you buy Treasury bills and the like, you’re buying the debt of the U.S. government.

No nation in the world sells more debt every single month than the United States. Because of our existing budget (that’s using the term very loosely), we are forced to borrow money every 30 days. To pay Social Security, welfare, medical payments, elected officials and bureaucrats, the military, foreign aid, student loans — anything and everything that gets money with a federal stamp on the check.

And we have to borrow it. Somebody has to give us their money with the expectation that they are going to get it back, plus interest (uninflated).

Now, imagine your neighbor asked you to loan him some money, promising to pay it back with interest. A week later, all that money has been spent… so your neighbor asks for another loan. And another. Then another. How much longer would you keep lending him money? Even if he continues to pay the interest he owes you, you still have to wonder how long before he needs to borrow money just to pay the interest he owes you for borrowing the money.

That’s why everyone I know is casting a wary eye on America’s “neighbors” — the countries holding much of the U.S. debt. With our massive spending plans and dim economic outlook, other nations must be worried about our ability to repay our debt. What will we do when the Chinese stop buying? What will happen when the European Central Bank stops buying? What will we do when Japan stops buying? Will the government stop spending even then?

One way or another, the you-know-what is going to hit the fan. Oddly enough, however, foreign investment is higher this year (43.1%) versus last year (only 27.1%). That’s a year-over-year increase of 60%!

So instead of being worried, the U.S. government feels invincible. Foreign countries will always be happy to buy our debt, it thinks, so there’s no reason to adjust our destructive spending plans. It’s like giving more liquor to an alcoholic to sooth his tremors — a short-term fix that doesn’t do anything to solve the problem. Make him feel good enough, and soon he won’t feel anything ever again.

If I were you, I’d position my short-term and long-term currency savings accordingly.

Regards,
Bill Jenkins

September 30, 2009

The Euro, the Dollar and the Future of the Forex was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.