This Monday morning I posted my thoughts on Market Forces and unfortunately, I only briefly mentioned my concerns about the Yen Carry Trade. I have been working on a very long (sorry) post about the subject for weeks, but things blew up before I could seem prescient. Oh well, now is maybe even a better time since it would have just been ignored anyway. So I made some modifications to incorporate the last several days and here it is:

The Yen Carry Trade has been going on for about 10 years since Japan initiated its zero interest rate policy in February 1999. At that time, the Japanese economy was in danger of the deflationary spiral of plummeting consumer prices and a deepening recession. With the exception of a few smarties, the Yen Carry Trade had been taken for granted for a decade and was rarely mentioned as a concern. When it was, the bulls either ignored it or ridiculed the concerns as being overblown. Now it seems that the entire world is an expert on the carry trade. Commentators are spouting their “knowledge” and the audience is nodding in agreement even though they probably have no idea what they are nodding about. Note that I am not an expert on it either so like anything else you hear, please come to your own conclusions.

A carry trade occurs when a speculator borrows in one currency and invests in another. In recent years, no market has been riper for carry trades than Japan because of the frequently weak Yen and near-zero borrowing costs during nearly two decades of recession. The Bank of Japan has raised its rates twice since 1999 - in July of 2006 and last month when it hit 0.50%. Many large investors like hedge funds, mutual funds, insurance companies, etc. have taken advantage of the Japanese debt and turned it into a potential money machine by borrowing Yen at almost no cost and investing it abroad in high yielding investments. That strategy works well in a bull market as long as debt remains cheap and more importantly, the spread between rates remains large. It’s one of the primary reasons for the extreme liquidity that has bid up prices around the world in multiple asset classes like real estate and fixed income, not just equities.

Remember that this has been going on and accumulating in size over a decade. So how big has the Yen Carry Trade become? No one really knows the exact number, not even the BOJ. But economist estimates are often near the $1 trillion mark with low extremes at $200 billion and high ones at $2 trillion. Regardless of the number - its BIG really BIG. After the US election, CEO’s from the Big Three automakers met with President Bush and whined that their failures were partly due to Japan’s undervalued currency(click here for the summary.) Furthermore, at the Group of Seven meeting Japan was pressured to do something about the carry trade and despite the G7’s warnings to investors about the risk of one-way carry trades, it was ignored. At least until this week and as I wrote on Tuesday night, be careful what protectionists wish for.

But when the spread starts to close, that’s where the real problems begin and risk pricing changes. So when the Japanese central bank raised its rates last month in response to its marginally growing economy and foreign political pressure, it makes a difference even though it was only a 25bps increase. And when the vice minister of the Ministry of Finance, Hiroshi Watanabe says rates may continue to rise - a reasonable response would be for investors to start reversing the carry trade or at least stop advancing it. Watanabe is also confident that Japanese consumption will recover this year but last night, Japan released its inflation figures and there was zero percent inflation. That might put into question future rate hikes but as we see, there are other factors influencing Japanese rates and currency than just inflation.

Unfortunately, the effects of an unwinding of the Yen Carry Trade are unknown, but they are sure to be very negative. We can look to a bit of history to get a reminder of what can happen and it involves our government meddling for trade and political purposes, sudden Yen appreciation, and a blow up. Sound familar?

The last time the Japanese economy strengthened enough to cause an unwinding of the massive Yen Carry Trade was in 1998, just prior to the LTCM collapse. In the spring of 1998, China was frustrated with Japan’s competitive trade position due to the weak Yen and the US bowed to Chinese insistence that the Yen’s depreciation be ended. In mid-June, the Federal Reserve intervened on the Treasury’s behalf to join the Japanese in selling dollars. Soon after, the Yen appreciated 15% over one week and caused a massive contraction of the carry trade. While government intervention was a contributing factor, the Yen appreciation likely had other causes. Followed by the Russian currency devaluation, we had the LTCM collapse and Russia’s debt default. The massive cooperation by the world’s central banks was the only way to solve this problem. Since then, the panic of 1998 has been largely forgotten and once Japan slid back into recession and deflation, the Yen Carry Trade was back on. How quickly we forget!

To the extent that Japanese funds have been invested in US Treasuries and equities, they will go down when the Yen carry trade is unwound but the speed and extent of those price changes are unknown. More importantly, we need to worry about the massive liquidity effects on high growth / higher return / higher risk economies and the assets in those areas. There are trickledown and multiplier effects if those assets decline and you need to keep an eye on some warning signs. Specifically, before this made the headlines, I was watching for a crack in the New Zealand currency since its appreciation was highly leveraged to the Yen Carry Trade and the beginning of an unwinding would be easier to isolate there. New Zealand’s benchmark interest rate is 6.75% higher than Japan’s. Yesterday and today, the New Zealand dollar did start to depreciate. However, now that this condition is widely followed, I don’t doubt that speculators are exacerbating this problem and taking advantage of the focused attention. As a result, I am not putting as much weight on it as I was before, but I am still tracking it.

As with everything else in the markets, things don’t seem to matter that much until it’s all we seem to talk about. Investors have become preoccupied with being told why the market moves one way or the other and the reasons offered by financial media and their guests are not always correct. The more they get repeated - the more they get accepted and that is what happened this week with the Yen Carry Trade. So to be fair, I’ll go on the record with regards to the Yen Carry Trade and challenge some of the assumptions repeated in the media with this summary of my thoughts:

• It took years to wind up the carry trade.
• The amount of the carry trade is likely near $1 trillion.
• The effect has been to create liquidity bubbles in multiple asset classes, not just equities.
• A 3-4% reduction in the US equities market is a small figure and I doubt it is related entirely to the Yen Carry Trade.
• A 3-4% appreciation in the Yen is a small figure and it is unknown how much is related to the unwinding and how much is related to speculation.
• I do not believe the similarity between the percentage of US equity decline and appreciation of the Yen represent a 1-for-1 potential for the entire effects of unwinding the carry trade.
• I also do not believe that the dollar values are 1-for-1. So if the Yen Carry Trade is actually $1 trillion, I don’t believe that the asset price decline will be limited to $1 trillion for a total unwinding.
• Unwinding the carry trade is a complex process that would take months to avoid great dislocations in the markets of multiple asset classes. Something so complex that takes years to build cannot be undone in a week with a small percentage change in asset prices.
• If you hear that the Yen Carry Trade is completely unwound or even materially unwound, be very skeptical.
• If you hear that risk has been repriced, be very doubtful because they said that about international ETF’s in May 2006. We recovered those prices in 5 months and exceeded the May highs for the past 3 months, inclusive of current levels. So how were risks really repriced? Higher??
• It is likely that the Yen Carry Trade WILL NOT be unwound any time soon.
• The fundamental reasons for the Yen Carry Trade have not changed materially. Japan is an export driven economy with a significant current account surplus. That has not changed this week and I don’t expect it to.
• Japan’s interest rate spread with the majority of industrialized and emerging market economies are still at very wide differentials.
• I believe that most of this week’s changes to the Yen Carry Trade are more reflective of short term speculative traders, and not systemic global capital flows.
• A Yen Carry Trade is NOT a risk-free transaction with guaranteed profit.
• There have been several weeks over the past four years with Yen appreciation roughly equal to or greater than the 3.4% that occurred this week. I do not remember those events being associated with the unwinding of the carry trade.
• There are many reasons for currency appreciation / depreciation and the Yen’s strengthening this week may have had more to do with them than the unwinding of specific carry trades.
• US stock markets are not highly correlated with weekly changes in the Yen.

I know others (especially the bulls) want you to believe that the Yen Carry Trade has been fully addressed this week. I couldn’t disagree more. If the market increases next week and the Yen isn’t repeated every few minutes, that does not mean the carry trade has been unwound. It just means that we stopped repeating it - simple as that. Besides, a rapid unwinding is a potentially cataclysmic event like we had in 1998, not a 3-4% selloff like this week. Personally, I don’t think the Yen Carry Trade will be unwound until the spread between BOJ rates and other central bank rates are relatively equalized. Hopefully that will occur gradually over years and along with it, a gradual unwinding of the associated carry trade. While Japan’s economy is growing and consumption may be on the rise, it is very fragile and could revert to a recession very rapidly. They have significant demographic problems (unfunded pension liabilities coupled with an aging population and low birth rates) that are hard to resolve regardless of currency appreciation. Global investors have been conditioned to exploit the carry trade for many years and I don’t think they are going to get scared into going “cold turkey” over a decline like this week. The last time around we forgot the risks very fast. What’s different now? As I said, I expect this to carry on.