Tags: Japan | US | carry | trade

I'm Quite Sure There Is Trouble Ahead

By    |   Tuesday, 30 September 2014 09:36 AM

After the Bank for International Settlements (BIS), in its Quarterly Review on international banking and financial market developments, and the G-20's final communique from its meeting in Cairns, Australia, signaled how central bankers had become markedly concerned about financial market conditions, Bank of Japan Governor Haruhiko Kuroda gave a similar warning Monday in a prepared speech to the International Bankers Association of Japan. He said, "Investment in high-risk assets such as high-yield bonds and emerging economies' bonds and stocks has been expanding considerably against a backdrop of declining volatility in interest rates, stock prices and foreign exchange rates, as well as investors' search for yields. . . . In any event, central banks cannot be unconcerned about the stability of the financial system."

I don't think it's an overstatement to say it becomes clearer by the day the Japanese yen-funded carry trade is slowly but surely closing up shop.

Of course, by far the most important funded carry trade with the U.S. dollar is already over. The euro could replace the dollar's funding role probably, but to a much smaller extent. However, it is still too early to be sure of that.

Long-term investors should keep in mind that for successfully funding carry trades you absolutely need a weak and "globally easy" tradable currency that maintains weak prospects and a low volatile environment.

We all know the dollar has fulfilled that role for the most part from March 2002 to July 2011. Some of exceptions in that time span include the period of the great recession as well as the months that followed November 2004 when then under President George W. Bush, Treasury Secretary John Snow gave his "remarkable" speech at Chatham House in London stating that there is "broad agreement today that the world economy is best served by open, competitive currency markets. . . . Our policy is for a strong dollar. Our dollar policy remains unchanged because a strong dollar is in both the national and international interest."

This time around we're witnessing the strongest yearly dollar performance since 2008, but it's still far from the highs we saw in 2002. The official views might be slightly different, officially at least, and already Chicago Fed Chairman Charles Evans, when talking about the strengthening dollar, said: "We're going to take that [dollar strengthening] into account, the way it's affecting the economy in terms of net exports and GDP growth and what it means for our inflationary developments."

I'm not saying Evans would like to start a currency war if he'd consider it as necessary, but he doesn't seem to me being hostile to it either.

In my opinion, Japan has already started its "stealthy" currency war with its Abenomics program that was implemented immediately after Shinzo Abe was elected Prime Minister in December 2012. However, only a few days ago the Reserve Bank of New Zealand intervened in the foreign exchange markets. And that probably won't be the last one.

There is no doubt that volatility is bound to rise, and it would be good to keep in mind that volatility is a serious enemy of the carry trade. This is important because in a low volatility environment, like the one we have experienced for about six years, investors could accept modest yields while maintaining a relatively certain degree of knowledge that they were unlikely to be taken out of their trade at any moment.

Low volatility also encourages fresh participants to engage into carry trades under the perception and conviction that new buyers would always be there on the dips, which, in turn, has fed into a steady upward trend in prices and further declines in volatility, and so on and so on.

A little bit more technically, these declines in measured volatility also encouraged investors to pick up additional yield by being prepared to sell off implied volatility. Of course, that's for traders and not for long-term investors.

That said, every day we're getting more indications that these kinds of trades have begun to break down and once such a trend is well underway it rarely ends in a benign fashion. In my opinion, we are in some kind of similar environment again where abrupt reversals are bound to take place in the foreseeable future.

No, I wouldn't take these important warnings from the BIS, the G-20 and the Bank of Japan lightly.

When the price of iron ore for immediate shipment to China traded on Monday at $77.70 a ton, which represents a decline of 42 percent since the start of the year and the lowest level since September 2009, while traders expect $77 per ton in October, this small detail tells me a lot about where China's growth is heading.

I'm not saying China is heading for a hard landing yet, but I have no doubt the second-largest economy in the world is in serious trouble, which will have a negative impact on overall global growth. I have no doubt about that.

What finally comes out of the Hong Kong protests (Umbrella revolution) is another matter, but if it would ever come to a real crackdown by the Chinese authorities, I wonder how and with what the U.S. and the European Union would react.

Besides all that, the EU problems remain well in place and didn't get any better so far. The official unemployment number for the eurozone remained stable at 11.5 percent in August, while the annual inflation flash estimate is down to 0.3 percent for September from 0.4 percent in August. In addition, the core personal consumption expenditure fell to a historic low of 0.7 percent year-on-year. We'll see what European Central Bank President Mario Draghi will tell us on Thursday during the press conference that follows the Governing Council meeting.

In the U.S. on Friday we'll have the important employment numbers, which are expected to be good.

When on Monday, the notorious International Center for Monetary and Banking Studies (ICMB), located in Geneva, Switzerland, warned in its 16th annual report that "the policy path to less volatile debt dynamics is a narrow one, and it is already clear that developed economies at least must expect prolonged low growth or another crisis along the way," I can't see any reason why I should change my preference for the U.S. dollar and the country itself as location for highly liquid, under all circumstances, assets.

I hope the people in Switzerland are mistaken, but to me it looks like quite sure there is trouble ahead. Anyway, nobody can say they weren't warned in time.

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I can't see any reason why I should change my preference for the U.S. dollar and the country itself as location for highly liquid, under all circumstances, assets.
Japan, US, carry, trade
Tuesday, 30 September 2014 09:36 AM
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