03-16-07

Carry on my wayward son
the fed will cut when you are done
lay your leveraged head to rest
don't you sell no more...
– with apologies to Kansas

Ah yes, the carry trade… borrowing in one currency to invest in another. Can anything be more deliciously speculative?

They say that risk is the mother's milk of capitalism. If true, that makes the Bank of Japan a prize dairy cow of sorts. The yen has been the funding source for many a leveraged bet these past few years; when you can borrow dirt-cheap and earn high yields for your troubles, life is sweet indeed.

The trouble is, even the sweetest of deals goes sour now and then.

The carry trade blowout of Fall 1998, for example, was particularly spectacular. Your humble Macro Musings editor was a wet behind the ears commodity broker at the time. Watching the yen go straight up for days on end, like a rocket ship approaching escape velocity from the earth's gravitational pull, was a truly mesmerizing experience.

The trouble back then, like the suspected trouble now, was with hedge funds. Long Term Capital Management was in the process of going belly up, and had a massive short yen position to unwind in full view of the street. Nor did LTCM suffer alone; Julian Robertson of Tiger Capital Management, a $22 billion firm at its peak, lost more than $2 billion in a single day on yen bets gone bad.

The fear now is that subprime pain will trigger a new hedge fund avalanche. As MSN Money editor Jim Jubak writes, "the biggest potential danger isn't from a slowdown in the U.S. or Chinese economies. It's from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan."

So does this mean we are witnessing a Yogi Berra phenomenon? "Déjà vu all over again?" Not quite. This time around, there is an interesting twist. Consider this eyebrow raising anecdote from the Wall Street Journal:

Now people such as Naomi Kashiwazaki, 29 years old, have joined the fray. She trades currencies from her small apartment in Tokyo's suburbs. She started about a year and a half ago to supplement the income from her online store, which sells designer athletic shoes that are hard to find in Japan. In recent months, she has earned an average profit of $8,600 a month.

"I must say, I am addicted to this now," she says.

Tens of thousands of other investors like her are doing the same thing. With Japanese interest rates hovering at a low 0.5%, they borrow big piles of yen cheaply and then invest it in currencies elsewhere, looking for higher returns. Ms. Kashiwazaki makes trades totaling $200,000 or so a day among several currencies, ranging from the U.S. dollar to the Swiss franc.

The WSJ article, titled "Japanese Addiction: Currency Bets," goes on to note that "Japanese individuals are essentially doing the same thing as hedge funds," and that their aggregate foreign currency holdings could run as high as 5 trillion yen—on par with the wizards of Wall Street.

Ms. Kashiwazaki, feeding her currency addiction from the suburbs, seems a miniature-scale version of "the Bubble Lady"—an iconic figure in Japan's late 80s market boom. Edward Chancellor recounts the Bubble Lady's tale in the below excerpt from Devil Take the Hindmost – A History of Financial Speculation:

Since speculative manias tend to undermine established structures, it was fitting that in this male-dominated society the greatest private speculator should have been a woman. Born in 1930 into a poor family, Nui Onoue began her working life as a waitress in the entertainment district of Osaka, Japan's second city. Later, she became the mistress of a construction company executive, who helped her purchase two restaurants in the 1960s.

For the following twenty years, Mrs. Onoue ran her restaurants without attracting notice. Then one spring day in 1987, she entered an Osaka branch office of the Industrial Bank of Japan and purchased over a billion yen's worth of the bank's discount bonds. Mrs. Onoue proceeded to borrow nearly three trillion yen ($23 billion), a sum roughly fifteen hundred times the value of her restaurants, which she invested in the stock market... Each shareholding was used as collateral for bank loans which enabled her to buy more shares.

Banks and brokerages fell over each other to do business with the "bubble lady"... Once a week, she held an all-night séance in her restaurant summoning the spirits to assist her speculations. Brokers were expected to attend these séances or risk losing her business. At dawn she would inform them of the names of the companies revealed to her. In the heady days of the bubble, such behavior was accepted without question. With a fortune rumored at half a trillion yen, she liked to boast that "with money all is possible."

Sadly but not unexpectedly, the Bubble Lady wound up bankrupt. Hopefully Ms. Kashiwazaki (and most of her compatriots) will avoid such a fate.

The question then remains: whither the yen? Are we headed for another meltup, similar to the great unwinding as seen in 1998? The trusty Magic Eight Ball says, "Reply Hazy. Try Again Later."

To be clear: it's the timing that remains uncertain, not the eventual outcome. The carry trade is going to go belly up sooner or later. It's just a matter of how long it takes.

Tens of thousands of Japanese currency speculators—the majority of them feeling pessimistic about the home front—could help keep the yen down through continued aggressive forays into foreign equity and currency markets. The more shorts there are to be squeezed, the worse the eventual carnage is likely to be... but resolve and capital keep the game intact in the meantime.

The Federal Reserve is also waiting in the wings, ready to cut rates in the event of a slowing US economy. A rate cut, or strong expectations of one, could bring relief to leveraged borrowers… which could in turn prolong the lifespan of the carry trade.

Ben Bernanke has expressed belief that the 2007 economy will be strong, but that is exactly what he's supposed to say. In contrast, the chatty Alan Greenspan has forecasted a one-third probability of recession this year; the inverted yield curve argues a fifty-fifty chance; and analyst David Rosenberg of Merrill Lynch believes recession probability to be "very close to 100 percent" if the Fed does not cut rates.

If the other subprime shoe drops in short order, or a sufficiently frightening skeleton tumbles out of the credit derivatives closet, the yen could get a move on fairly quickly. If neither of those occur quickly, however, and hedge funds suck in their gut as they did with Amaranth, the practice of borrowing and selling yen could "carry on" for some time yet.

For those who don't mind being patient—and would rather be positioned early just in case—there are a number of ways to play the eventual unwinding of the carry trade. Going long or buying calls on FXY, the new Japanese yen currency ETF, is one way. Shorting or buying puts on DBV, a sort of ‘carry trade ETF' that sells low-yielding currencies and buys high-yielding ones, is another. (If the yen skyrockets, DBV will plummet.)

One could also consider a longer term short on export-oriented Japanese companies, like Toyota (TM); if the yen rises sharply, Toyota's profits will be slashed, and the play offers a bearish twofer with the added angle of slowing consumer spending. And of course there are yen futures, e-mini yen futures, and even interbank currency opportunities for the more aggressively inclined.