Sucheta Dalal :A yen for the Yen
Sucheta Dalal

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A yen for the Yen  

February 15, 2007

"Carry on living dangerously", says the headline in The Economist.

It was talking about the global borrowing binge based on selling the
Japanese yen - also known as the yen carry trade. Here we stake out a
contrarian position:

Want to make some money in 2007, dear reader? Buy Japanese stocks. To
explain, we start with our own money lenders at home:

Ben Bernanke sat down in front of a team of Congressmen and told them that
everything was fine. Inflation, quoth he, would be 'moderate.' Growth
would be 'moderate.' If there was anything not moderate, Bernanke didn't
see it.

All this moderation went to investors' heads. As we watched the reports on
CNN last night, every stock market in the world seemed to be going up. The
Dow ended - up 87.

Maybe Bernanke will be right about the moderation; we don't know. But if
the world enjoys another year of comfort, it will do so at great
expense...great risk...and great future discomfort. Because behind the
moderate GDP growth numbers are some other numbers that are outrageous.

We could refer to central London property compensation in the
financial the Shanghai stock market...or to the latest figures
from the art world. We could focus on any number of other things...but
today, we focus not on the symptoms, but the cause...or, at least one of

Speculators borrow yen, trade the currency for dollars, and then buy
Treasuries or U.S. properties or U.S. stocks. The Bank of Japan lends
money at only 0.25%. This it has been doing ever since the mid '90s, when
the BOJ sought to get the Japanese economy out of its funk by making money
easier to get. A hedge fund, for example, can take advantage of this low
interest rate by borrowing yen at, say, 1% and buying U.S. bonds at a 5%
yield. Or, he can be more aggressive and go for 7% by buying New Zealand

What makes the transaction dangerous to the speculator is that the yen may
rise. What makes it dangerous to everyone else is that there are so many
people who owe so many yen. And what makes it so attractive to contrarian
investors is that with so much money counting on the yen to go
is almost sure to go up.

If the yen were to rise 6% the speculator's profit would be wiped out. And
since these transactions are almost always highly leveraged, his capital
could be wiped out too. This is exactly what happened when the most famous
hedge fund of all time blew up in the late '90s. The yen went up.

The Russians had a financial crisis. Speculators looked at their holdings
and decided to unwind some of the leverage. That meant selling their
assets and repaying yen. Of course, to repay yen you have to have yen. So,
you've got to go into the currency market and buy them - which pushes up
the price of yen. In 1998, the yen rose about 25% against the dollar in
the space of a few weeks and Long Term Capital Management went bust.

Nobody knows how much of this 'carry trade' there is...but today, there is
almost certainly a lot more than there was ten years ago. Today, there are
thousands more hedge funds and many more speculators - with billions more
to work with - all betting that the yen will stay put.

And as we know, now even homeowners have become speculating geniuses, so
we shouldn't be too surprised to find that homeowners are financing their
homes in yen. Yes, that's right. According to the Financial Times,
"households in Latvia and Romania have developed so much enthusiasm for
borrowing in yen that the trend has provoked surprise - and unease - from
central bankers half a world away in Tokyo."

Altogether, some experts estimate the total 'yen carry trade' at a
trillion dollars. And it is all short. That is, the success of all these
trades depends on the yen NOT going up. Which is what makes it so
dangerous to the entire world financial system...and so attractive to the
investor willing to go long.

What surprises us is that America's subprime lenders have not yet caught
on to the financing opportunities of yen loans. If buyers were willing to
go for Neg Am, I.O., limited doc ARMs why not Neg Am, I.O. limited doc,
yen ARMs?

But therein lies the risk, and the opportunity. Yen, like dollars and
derivatives, are subject to 'adjustable rates.' True, the rates have not
been hiked in a very long time. And true too, the yen has cooperated by
going down (naturally, people have to sell the yen they borrow in order to
buy higher-yielding investments). This has only heightened the risk. The
lower the yen goes, the higher it is likely to bounce when it finally hits
bottom. The Economist's Big Mac index, comparing the cost of buying a Big
Mac around the world, finds the yen already 40% too cheap. So, there's
plenty of room for adjustment.

"Now, as in 1997," Hans Redeker, who heads currency strategy at BNP
Paribas, explains, "low-yielding currencies have been used as the global
cash machine, pushing liquidity into asset markets. In 1997 the Asian
crisis marked the end of this development. This year we suggest that
emerging market assets and equity markets could set the turning point,
sparking carry trade liquidation."

You want to make a good investment, dear reader? Buy Japanese stocks.
Either the stocks will rise...or the currency will. If the economy
continues on its 'moderate' course, Japanese equities should do well. If
moderation gives way to panic, the yen should go up.

Taken from The Daily Reckoning Newsletter

-- Sucheta Dalal