Tags: carry | trade | euro | yen

World Needs Complete and Sound-Functioning Economy in the EU

Tuesday, 03 June 2014 11:17 AM Current | Bio | Archive

Lately, many investors have had a lot of unanswered questions, particularly about what has been going on in the foreign exchange markets, where we have seen persistent low volatility and what it could mean for where we could go from here.

Interestingly, only a little bit more than a year ago (Feb. 11, 2013) the Institute of International Finance, which is the world's biggest bank lobby representing more than 470 financial institutions worldwide, was urging the Group of 20 Finance Ministers and Central Bank Governors, which includes the G7 (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), to set out a coherent position on currencies, warning that failure to do so risks exacerbating the already extreme volatility in foreign exchange markets.

Now, long-term investors would do well to take notice of the very unusual fact that during the past few weeks, various G7 finance ministers and G7 central bankers have openly started complaining about "lack of volatility" in financial markets.

For instance, on May 19, Dallas Federal Reserve President Richard Fisher said one of the things that concerned him was "we have no volatility in the markets." His statement came after he said on April 4 before the Asia Society Hong Kong Center in Hong Kong: "I question if it is sound policy to remove all uncertainty or volatility from the market. . . . Calendar-based commitments can lead, perversely, to market instability by encouraging markets to overshoot, as they appear to be doing in some quarters at present."

Last week, Ignazio Visco, a member of the European Central Bank (ECB)'s Governing Council and governor of the Bank of Italy, stated: "Volatility on the financial markets in the advanced economies has subsided to well below the historic norm, reaching levels that in the past sometimes preceded rapid changes in the orientation of investors."

I think we are in an environment that echoes the great carry trades of the mid-1990s as well as the one of the mid-2000s, when we witnessed substantial declines in market volatility that accompanied the respective carry trades during those periods.

By the way, carry trade is a strategy that is very common among the foreign exchange market players whereby one borrows in a low-interest currency and invests it in a high-interest currency. This can go on for quite some time, but not forever as we all know. Nevertheless, as long as it works, contracts are rolled at maturity or reversed if the direction of the rate differential has reversed.

Keep in mind carry trades only perform well when volatility remains low. Once volatility spikes, carry trades are no longer profitable, and if linked to (wrong-sided) leverages, a complete and sudden annihilation of all values is the result. This happened on Oct. 7, 1998, when Japanese yen-funded carry trades came to an abrupt end and the dollar/yen pair exchange rate collapsed 1,200 basis points in only a matter of hours.

This historical downward move came just after Long-Term Capital Management, a hedge fund management firm based in Greenwich, Conn. that utilized absolute-return trading strategies combined with high financial leverage, collapsed and a subsequent broad retreat from risk took place in the days that followed.

About one decade later we witnessed a similar event.

During the summer of 2007, investors showed broad-based complacency and were willing to take on a lot of apparent, but also not so apparent, risks. Interestingly, also at that moment and in some way similar to what we have today, we saw 1) yield spreads between peripheral and core euro area government bonds had come down to practically nothing, 2) major stock markets were trading at multi-year highs after having trended higher for the previous three of four years and 3) the price of implied volatility in currency pairs such as euro/dollar and the British pound/dollar were trading at multi-year lows.

Also during that period, the major source of funding/carry trades of these three groups of activities was crystal clear, as the speculative "shorts" of the Japanese yen at the International Monetary Market, which is a division of the Chicago Mercantile Exchange, stood at a record level at the end of June 2007.

During that same month, on June 22, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the Bear Stearns High-Grade Structured Credit Fund, which would in fact be the moment that would lead to the 2008-09 worldwide financial crisis.

During the next five months, speculative short positions were wound up entirely while the Japanese yen embarked on a four-year uptrend that ended in December 2012 when "Abenomics," which refers to the economic policies advocated by Japanese Prime Minister Shinzo Abe that are aimed to weaken the Japanese currency, was implemented.

Even for the euro area bond markets, the summer of 2007 would ultimately prove the turning point for many of euro area key yield spreads.

Finally, the end of June 2007 also proved the turning point for volatility in the foreign exchange markets, returning to more normal levels by the end of the year. The dollar/yen declined (stronger yen) from 123 yen per dollar at the start of July 2007 to an intraday low of 96 yen per dollar at the start of 2008, or a move of approximately 22 percent, with volatility going through the roof.

With today's volatility being at about the lows we saw in 1997 and 2007, while peripheral euro area yield differentials with U.S. Treasury yields and German Treasurys having come down to extremely low levels (e.g., the 10-year Spanish sovereign yields only 0.3 percent more than the 10-year U.S. Treasury does), I think the time is right for long-term investors to get extremely cautious.

In my opinion, the carry trades that have brought down the sovereign yield spreads in the euro area, and have thereby supported in part the euro against the dollar, are close to ending their course.

Keep in mind, carry trades build slowly, but they often end swiftly, as there is no last mover advantage for remaining in the trade. No, nobody wants to be the last one who holds the bag.

In the meantime, the Eurostat EU inflation flash estimate came in at 0.5 percent for May, which was below expectations and down from 0.7 percent in April. ECB President Mario Draghi has said the ECB would closely watch the flash estimate when deciding next Thursday whether or not to lower the ECB key interest rates and/or announcing stimuli for the euro area economy.

In my opinion, the ECB has practically no other choice than to ease. The big question remains by how much and how the ECB would do that in accordance to what is allowed within its mandate?

Also, the unemployment numbers of the euro area edged a tenth of a percentage point lower, to 11.7 percent in April 2014, down from 11.8 percent in March and down from 12 percent a year ago. Unemployment in Italy came in at 12.6 percent, up from 12 percent in April 2013; Spain came in at 25.1 percent, down from 26.3 percent; and Germany came in at 5.2 percent, down from 5.3 percent.

For comparison, the unemployment rate in the United States was 6.3 percent in April, down from 7.5 percent in April of 2013.

Yes, unfortunately, the euro area and the United States continue to drift further apart, and that's bad news for everybody.

Also, don't forget there is a big probability we'll see interest rates starting to rise in the United States during 2015.

It remains obvious the euro area remains a zone plagued with destructive divergences between the core and the peripheral nations. The multimillion-dollar question remains what are they really going to do about it, as there is no one-size-fits-all solution at hand?

The euro area troubles are not over yet, and if it doesn't get seriously better in the foreseeable future, we could get very nasty surprises, such as further growing anti-EU sentiment and the resurgence of unsound forms of nationalism.

It would be wise to keep in mind the world as a whole, including the United States, needs a complete and sound-functioning economy in the European Union. That's certainly not the case today, albeit with a few exceptions.

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Lately, many investors have had a lot of unanswered questions, particularly about what has been going on in the foreign exchange markets, where we have seen persistent low volatility and what it could mean for where we could go from here.
carry, trade, euro, yen
Tuesday, 03 June 2014 11:17 AM
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