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Monday, April 10, 2006


the krona

chaotic events in distant lands are common news items in the back pages of american papers. indeed, one of the telltale signs of a society whose imperial ambitions are boundless is an overweening concern for such matters, which would ordinarily have little import on affairs closer to home.

but the wall street journal today highlights one chaotic event in one distant land that may have more to tell americans that we would wish it to. the icelandic krona has collapsed dramatically in recent weeks with its small equity market plummeting in tandem.

the turmoil began with a publication by fitch warning of "macroeconomic imbalances" that could undo the krona, one of the greatest beneficiaries of the global carry trade. explains the journal:

In Iceland and a few other countries -- including New Zealand, Turkey and Australia -- investors found a lucrative way to take advantage of [Japanese] low rates: They borrowed vast sums in places like Japan (where rates are near 0%), and invested the money in places like Iceland, where rates stand at 11.5%. The maneuver, known as the "carry trade", has emerged as one of the most popular hedge-fund strategies in recent years.

But it can leave an economy vulnerable if the speculative money suddenly reversed direction. In one of the first signs of how Iceland's woes could affect other markets, on Wednesday, shares of easyJet PLC fell 9% after an Icelandic investor, FL Group, sold its 17% stake in the British carrier. FL Group said the sale wasn't related to Iceland's problems. But it is raising concerns that Icelandic investors, who went on an overseas buying spree in recent years, might have to sell holdings abroad to cover obligations at home.
this page has discussed the carry trade and its unwinding at some length. taken in conjunction with the recent market collapses in the middle east -- including turkey, another carry trade beneficiary -- iceland's crisis may very well represent the canary in the coalmine of global finance. the slowing economic conditions and inverted yield curve in the united states in combination with the end of quantitative easing in japan is giving speculators great reason to begin to undo these trades, which play yield differences with massive amounts of leverage by borrowing at low short-term rates and buying higher yielding instruments -- be they western mortgages, emerging market debt or equities. these inflows of ready capital have fuelled what can only be called a speculative credit bubble in multinational housing (including notably the united states), as well as asian and other emerging debt and equity markets.

the end of quantitative easing in japan is a topic that merits further discussion. a recent issue of the economist carried this article regarding a major chance in strategy for the bank of japan.

ON MARCH 9th the Bank of Japan (BoJ) declared that the days of its ultra-loose monetary policy were over and that it was winding down its unorthodox practice, begun five years ago, of flooding the banking system with free money. This drastic measure, known as “quantitative easing” was designed to pull Japan out of deflation after the cutting of interest rates to nil had failed to do the trick.

In keeping with modern, open central-banking fashion, the BoJ has also supplied a much-needed peek at the map it will use to steer itself back to a more “normal” monetary policy: one that is conducted by varying interest rates, not the quantity of money. Even so, because Japan is about to embark on an unusual journey, the way ahead is bound to contain surprises.

... The bank's first, delicate job is managing a smooth end to quantitative easing. In effect, this policy has consisted of stuffing the reserve accounts that commercial banks must keep at the BoJ with free cash. These accounts contain ¥30 trillion-35 trillion ($260 billion-300 billion), far more than would be required simply to keep overnight interest rates at zero (about ¥6 trillion). The idea was to get banks with shrinking loan books to lend more and so boost the economy.

There is a danger of mopping up that liquidity too fast, especially if prices ease again (as they might, once last year's rise in energy prices works its way out of the figures). But there is also a danger of mopping too slowly, and letting speculation take hold in markets for financial assets and property. The effect of the BoJ's largesse is already plain in the stockmarket, where day traders buying on margin were a big force behind the market's 40% surge last year. The policy has been felt in all sorts of foreign markets too (see article).
this second article highlights some of what this page feels all too likely to come down the pike.

IF YOU were charitable, you would say it had the elegance of simplicity. If you weren't, you'd call it obvious. The “carry trade” is, however, one of the most talked-about trading strategies of recent times.

The favourite subject of the masters of capitalism has much in common with the dinner-table topic of choice in large parts of the English-speaking world: making money from the property market. Both involve borrowing cheaply to buy something with a higher expected return. The carry traders, however, have travelled further than housebuyers in pursuit of lucre. Lately, they have gone to Japan, to borrow yen for next to nothing, convert it into other currencies, and buy anything from emerging-market stocks to gold, property and Kenyan shillings. While it has lasted, the trade has brought an air of old-fashioned derring-do to international capital markets; after all, as long as the yen holds steady or depreciates, it is hard to lose. But the end of Japan's ultra-loose monetary policy, signalled this week, might make the carry trade look a good deal riskier. This gives speculators the willies. Some, theatrically, believe it could cause the “avian flu” of global financial markets.

... Even if [BoJ] carry on regardless, the world's investors still have good reason to be cautious about Japan. First, Japanese corporations' years of deleveraging, which have helped fuel the global liquidity glut, may be ending, says John Richards of Barclays Capital in Tokyo. That may affect Japanese demand for foreign assets, such as American Treasuries.

Second, the BoJ has been responsible, along with America's Federal Reserve and the European Central Bank, for an exceptionally long period of unusually accommodative monetary policy. The other two have already begun to tighten. If policy becomes still tighter all round, it is hard to see global bond yields staying at their recent low levels (see chart). And third, investors might ask whether it is worth hunting out high-yielding assets in emerging markets and leveraged credit markets, if they can get attractive returns in safer places.

Such thoughts may already be permeating global bond markets, where yields on ten-year American Treasuries, German bunds and Japanese government bonds have risen in recent weeks. Further rises could be unsettling in a global economy where consumers, governments and many buy-out firms are leveraged to the gills. The BoJ is unlikely to be overly troubled by the interests of those bloated borrowers. Which is why they should be watching the bank's every move.
the amount of capital borrowed in japan and tied up in these trades is not definitely known -- but is almost surely constitutes a significant part of the most massive fiscal and monetary imbalances in the history of western capital markets. literally trillions have been borrowed to take advantage of the disparate returns between nations and markets as the american federal reserve held rates too low for too long over the last few years in the aftermath of the 2000-2002 nasdaq crash.

to note that the united states is also one of the great beneficiaries of the carry trade is to note that it too is vulnerable to financial shocks of a like kind. america is deeply dependent on the gargantuan and continuous inflow of foreign capital, as demonstrated by its truly staggering current account deficit. while much of that capital has been the investment of chinese and japanese central banks in currency manipulation, some of it is certainly hot money borrowed in japan that will be removed as japanese rates rise and yen liquidity declines. once such unwinding of the carry trade is begun, the potential consequences in an environment of trillion-dollar deficits are nothing short of earth-shaking -- and can quickly take on a life and mind of its own by the force of unintended consequences.


Are you the reason why gold has gotten so expensive recently?


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i sometimes wish i could say i was that consequential, mr mk, but i am not. :)

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