Posts Tagged ‘carry trade’

Shift in market psychology

Tuesday, December 15th, 2009

The 4th December 2009 should be noted in your diary as the day where the market psychology has changed.

Prior to that day, any economic numbers that was better than expected will be interpreted by the market as being ‘good’ for commodity prices. The idea is that ‘good’ numbers imply economic recovery, which implies increased demand for commodities, which in turn implies rising commodity prices. As a side effect, the US dollar trends lower. The converse is true for economic numbers that was worse than expected.

After that day, there is a major shift in the market psychology. As we wrote in What happened to gold prices?, when the market believes that the economy is going to recover, it will anticipate and speculate on interest rate hikes by the Fed, which is bad for stocks and commodities and good for the US dollar. The logic, as we wrote in November 10 at Booming real economy, falling stock market?, goes like this:

A truly recovering real economy will result in liquidity draining out of the system. Since the current rally is fuelled by massive loosening of liquidity, draining liquidity will imply that the stock prices will fall and the US dollar strengthens. As the US dollar strengthens, then the short squeeze in the US dollar will happen (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which implies that the Aussie dollar and stock prices will tank.

Right now, the market is believing in the economic recovery story (which we are sceptical). This belief is not that strong yet because there is yet to be a large scale move in unwinding the US dollar carry trade.

Some of you (who are trading in paper gold) may be concerned about what’s happening to the gold price lately. But remember, the main story is the reversal of the US dollar carry trade (which will result in a rising US dollar). Gold (or whatever commodity you are trading) is not the lead actor in this story. If you notice, not all commodity prices are moving down in unison, unlike the great de-leveraging of 2008-2009. Falling commodity, gold, silver and stock prices are just the symptoms of the reversal of the carry trade. To the extent that the rise of the Aussie dollar is the result of the carry trade, this will imply a weakening Aussie dollar (see Return (and potential crash) of the great Aussie carry trade).

If you are investing in physical gold bullion, there is nothing to worry about (see our book, How to buy and invest in physical gold and silver bullion).

Tags:
Posted in Commodities, Currencies, Gold, Market Observations | 6 Comments »

Return (and potential crash) of the great Aussie carry trade

Monday, October 5th, 2009

Since April 2006 to the July 2008, the main narrative for the Aussie dollar is that it was going to reach parity with the US dollar. As you can see from our Market Club chart, during that period of time, the trend of the AUD was up:

USD/AUD trend from October 2004 to October 2009

USD/AUD trend from October 2004 to October 2009

Back then, short-term interest rates in the US was down while in Australia, it was still going up. Then as the Global Financial Crisis (GFC) struck, Australia’s rising interest rates trend was reversed into a hasty cuts by the RBA. That was the period when the AUD fell precipitously in the context of global deflation. Then in the context of “green shoots,” zero short-term American interest rates and the RBA’s hints of more interest rates hikes to come, the AUD returned to an upward trend again.

In a world of plentiful highly portable hot money, interest rates differential is one of the major drivers of such high volatility between currencies. Twelve months ago, as we described in Another complication in RBA?s interest rate cut,

Now, let?s put yourself in the situation of say, a rich Arab investor with plenty of cash (US dollars). Previously, when Australia?s short-term interest rates were high and rising and the Australian dollar was appreciating, it was pretty good to convert your US dollars into Australian dollars and park your money in an Australian term deposits. The biggest risk for you is that the Australian dollar may depreciate, resulting in a loss as measured in terms of US dollars.

Today, we have a rapidly falling Australian dollar and a RBA signalling its intention to cut interest rates. What will you do? Obviously, you will want to pull out your money from Australia as soon as possible. If the other foreigners are thinking the same, you can expert further downward pressure on the Australian dollar, which will increase the pressure for more foreign money to pull out of Australia. This is going to be a problem for Australia.

Today, the situation is reversed. The very same hypothetical Arab investor is going to pump more of his excess zero yielding US dollars into higher yielding Australian dollars. Not only that, zero yielding US dollars will tempt many money shufflers to borrow money for free in the US to be ‘invested’ in Australia. The RBA’s threats to raise interest rates are sure to tempt even more hot money to flow in. As the AUD rose further, it made this carry yet even more profitable, which further lured in more hot money, which in turned caused the AUD to appreciate even more. Some of these hot money is sure to find its way into the Australian stock markets (instead of the safer high yield cash deposits). The formula looks pretty simple:

  1. Borrow money for free in the US, courtesy of Ben Bernanke.
  2. Buy AUD to be ‘invested’ in Australia (i.e. short the US dollar).
  3. If you are more risk adverse, put the AUD into government guaranteed term deposits, courtesy of the Australian tax-payers.
  4. If you enjoy risk taking, punt on the Australian stock exchange and/or capital raisings.
  5. Watch you wealth grows as the AUD appreciate and Australian stock prices trend up. With the RBA expected to raise interest rates, watch in glee as your potential returns increases.
  6. At the first sign of trouble, (1) liquidate your Australian stocks and pull out all your government guaranteed term deposits immediately, (2) sell the AUD to buy back the USD, (3) repay the free money borrowed from Ben Bernanke, (4) pocket your easy profits and (5) retire in Bahamas, thanks to the American and Australian tax-payers.

If you are a small investor, take note of step 6. At first sign of trouble, you can expect the AUD to fall sharply. In fact, judging from the recent tiny rebound in the USD (and fall in the AUD), some of these hot money are already executing point 6.

If this trend reversal becomes entrenched, we can expect tighter credit conditions in Australia (because Australia are net borrowers of foreign money) and the stock market to fall. Then the mainstream media will start to chatter of how ‘confidence’ has fallen in the market. If this chatter continues for an extended period of time (‘justified’ by falling stock prices and AUD), then consumer sentiments will start to follow as credit conditions tightens at the same time. As consumer confidence declines, aggregate spending will decline, which will in turn pull down more economic ‘indicators.’

The Indians will be carrying more firewood soon (see Do sentiments make the economy or the economy makes the sentiments?).

Of course, the Black Swan that can derail this scenario is further government interventions (which in turn will carry more Black Swans of unintended consequences).

Tags: , ,
Posted in Currencies | 12 Comments »

Is the real reason behind the Shanghai rout due to something else?

Wednesday, February 28th, 2007

Last night, the Shanghai casino (stock market) fell in a stampede of panic, triggering a worldwide sell-off. For us, we are not the least surprised to see that. In fact, as we advised back in January this year in Discerning a stock market bubble, that was the time to exit the Chinese stock market. Coincidentally, within less than a week after our warning, it corrected. Yesterday was the second major correction within a month.

Now that the dust had settled, we are wondering why did a Chinese sell-off create such a ripple effect to the rest of the world?s stock market. The previous correction of 4.92% at the end of January was hardly news at all. Surely, the magnitude of yesterday?s correction, though greater than the previous one, should not be the reason for such a contagion?

The ?official? reason for this market correction was that a rumour of the Chinese government?s intention to crackdown on speculation triggered the sell-off in Shanghai. While this reason may be true in the general sense, we guess nobody knows the real underlying reason. Here, we offer our speculative hunch (which require more investigation to confirm)?this may have something to do with the yen carry trade. Back in January, in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned about Marc Faber?s prediction about a coming severe correction in all assets class in the coming months. Though he did not fully explain the underlying reason behind this prediction, he did mention about the idea of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of liquidity). Thus, we believe that when he made that prediction, he saw a coming liquidity crunch in the days ahead. Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we did ask this thought provoking question: Are we now ripe for a contraction in liquidity?

A week ago, in Another source of potential financial crisis?reversal of yen carry trade, we did mention about the ramifications of a potential disorderly reversal of the yen carry trade. Much of the world?s liquidity can find its source in Japan through its near zero interest rate policy. However, it is obvious that the Japanese will normalise their interest rates sooner or later, which means the yen carry trade will have to end one day. The question is, whether this end comes through an orderly or a disorderly process. A disorderly process means that non-Japanese assets will have to be quickly liquidated and yen re-purchased to pay back the yen-denominated credit. This will result in a rapidly falling non-Japanese asset prices and a swiftly appreciating yen. Recently, Japan had raised its interest rates to 0.5%. Also, Japanese inflation is picking up and their stock market is trending up. The indications point towards the Japanese tightening up their liquidity. Perhaps someone reversing their yen carry trade on frothy Chinese stocks started the Shanghai rout?

Anyway, this is just our hunch?we are prepared to be proven wrong on this. But if our hunch is right, this means that there will be more corrections to come. That may explain the severe reaction of the global stock market.

Tags: , ,
Posted in Looking Forward, Market Observations | No Comments »

Another source of potential financial crisis?reversal of yen carry trade

Monday, February 19th, 2007

Interest rates in Japan had been zero for many years. It was only until recently that it had risen to only 0.25%. Such an unusual financial phenomenon sparked an interesting money-making opportunity?the yen carry trade. Basically, in a yen carry trade, you borrow money in Japan (where the interest rate was zero and is now 0.25%) and lend in countries with much higher interest rates. The interest rates differential makes up your profit. There are many ways to play with the yen carry trade. The most conservative way is to invest the borrowed money in US Treasuries. No doubt, there will be some hedge funds who want to achieve higher but more risky returns by investing in more risky assets such as stocks and Shanghai real estate.

What is the risk with this kind of strategy? Well, this strategy counts on the exchange-rate of yen not rising. A rising yen can wipe out your interest rates differential profits, even possible resulting in losses. Thus, the next crucial question is: what can result in an appreciation of the yen? For 16 years, Japan lived under the threat of deflation and economic malaise?that is the reason why the Japanese central bank made its money as cheap as possible (i.e. zero interest rate) in an attempt to counter such an economic threat. It is only until recently that the first lights of economic recovery can be seen. At this point in time, the Japanese economy is still dependent on exports to grow, which means that they have an interest to keep the value of yen low.

What will happen if the Japanese economy finally makes a confirmed recovery back into normality (there are signs that the Japanese economy may be recovering?read this report)? We can bet that Japanese interest rates will rise, thus putting a squeeze in the carry trade profit margins. More importantly, it means that the Japanese are finally willing to allow their yen to appreciate. Any appreciation of the yen will result in massive reversal of the yen carry trade, which in turn will trigger further appreciation of the yen, resulting in a self-reinforcing feedback loop. The danger right now is that a massive amount of yen are being borrowed (some experts says it is worth a trillion dollars), which in effect is a gigantic bet that the yen will not rise. A disorderly reversal of the yen carry trade will almost certainly mean that there will be losses in terms of billions of dollars, triggering yet another financial crisis. We will then see the collapse of many hedge funds.

The bad news is: This is just the beginning.

Tags: , , ,
Posted in Looking Forward | No Comments »