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The Yen Carry Trade Revisited

(September 21, 2006)

Dear Subscribers and Readers,

As of Wednesday evening, September 20, 2006, as I am typing this, it seems like nothing can derail the latest market rally from mid-August – not the coup in Thailand, the earnings warning from Yahoo, and nor the lowest homebuilder sentiment from the NAHB since February 1991.  Like I said before, I hope none of our subscribers are caught on the wrong side of this rally.  As we had mentioned in our previous commentary, we had been waiting for some kind of correction to go fully long in our DJIA Timing System.  That did occur a little bit on Tuesday, but we had wanted to take a “wait and see” approach – given the beginning of earnings warning season and given the uncertainty surrounding the coup in Thailand (plus the fact that the week after options expiration in September is usually a down week).  Will the action on Thursday or Friday provide an entry point?  We will soon see.

Speaking of being on the wrong side of a trade, I also hope none of our subscribers was on the long side of natural gas recently, as futures prices for both the next winter and spring have declined by nearly 30% in the last four weeks.  This latest decline was further compounded with the liquidation of the Amaranth hedge fund in its natural gas positions (and other energy positions – possibly gasoline and crude oil as well) as it lost approximately 65% of its assets this month alone.  Now that the liquidation of the hedge fund has ended, calm should logically return to the energy markets – unless there is another major hedge fund out there that have lost a significant chunk of its portfolio due to the Amaranth liquidation (which I would not be surprised about).  Because of this, and because of the fact that both the crude oil and the natural gas price are still significantly above the marginal cost of production, I urge our subscribers (those who want to go long energy) to at least wait another week or so before even considering a long position in crude oil or natural gas.  Even then – as I have mentioned before – any trade on the long side in the energy complex should be strictly short-term in nature.

The decline of natural gas, crude oil, and gasoline prices should not be a surprise, given that this is a theme I have been harping on for the last few months.  For example, in our April 30, 2006 commentary (“Divergences and the Dash to Trash”), I stated:

Speaking of commodities and emerging market equities, Bill Miller of Legg Mason (who has the enviable record of beating the S&P 500 for 14 consecutive years – not an easy feat for a mutual fund manager) had this to say about these “asset classes” in his first quarter commentary last week.  I will quote:

A big difference between today and the commodity bull markets of the 1970's is that then the US Fed monetized the rise in prices leading to persistent inflation. Today central banks are withdrawing liquidity, not adding it.  So far there has been no impact on commodities, and except for a few scattered areas of the world, most assets and markets are continuing to rise. I think that will get more difficult to sustain, especially if liquidity becomes scarcer. The first to feel the pain could be where the gains have been the greatest, which would be emerging markets and commodities


The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising. People want to buy today what they should have bought 5 or 6 years ago; call it the 5 year psychological cycle. Today people want commodities, emerging market, non US assets, and small and madcap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and internet and telecom stocks, and venture capital and US mega caps. The time to buy them was in 1994 or 1995, when they were cheap. But in 1994 or 1995, people wanted banks and small and mid caps, which should have been bought in 1990, and well, you get the picture.

Many subscribers have contended that this secular bull market in commodities will last 10 to 15 years.  I concur with this, since there has been an extreme underinvestment in many of the sectors that are involved in producing commodities from the early 1980s – such as oil & gas drilling, refining, gold, silver, copper, iron ore, uranium mining operations, and so forth.  At the same time, we are seeing unprecedented surge in demand from the emerging markets, especially China and India.  However, readers should keep in mind that the uptrends in many commodities over the last three years or so have been extreme in their own right – especially in commodities such as copper, natural gas, and zinc.  Moreover, just like the various sectors in the stock market, every commodity is different.  That is, not all commodities are going to top out at the same time.  For example, during the 1970s bull market in commodities, cotton prices effectively topped out in September 1973 – a full six years and four months before the final top in gold and silver prices.  Sure, cotton made a somewhat higher high in October 1980, but anyone who held on after the September 1973 top was effectively wiped out …

As of last Friday at the close, the cash cotton price closed at 47.5 cents per pound – half the price of the peak in prices during September 1973.  More recently, the rise in natural gas prices that we experienced last year has also been corrected in a big way – with the current spot price below $7.00/MMbtu and with the January 2007 contract closing at $11.36/MMBtu last Friday.  This is a far cry from the $15.50 gas price that we experienced right before Christmas of last year.  Should our natural gas infrastructure remain intact during the hurricane season this year, then natural gas (deliverable during the winter) could effectively retest the $10 level – even should we experience colder-than-normal weather during the upcoming winter.

In the meantime, readers should be very careful of a huge correction in commodity prices – even though the secular bull market in certain commodities may not be over yet.  As stated by Bill Miller: “A big difference between today and the commodity bull markets of the 1970's is that then the US Fed monetized the rise in prices leading to persistent inflation. Today central banks are withdrawing liquidity, not adding it.”  Even though there is still excess liquidity in the system (courtesy of the Bank of Japan), they have been quickly mopping it up and continues to do so at a frantic pace.  Read: The secular bull market in commodities over the next five to ten years will be purely determined by demand and supply – and not by excess monetary inflation that we experienced during the 1970s (preceded by an ill-advised policy of price and wage controls).  That is why this author is skeptical of any major rally in agricultural commodities – most notably cotton, wheat, and so forth.  As for copper – if there is truly a corner being currently conducted by a group of hedge funds (which isn't overly difficult since the U.S. copper demand is only worth $12 billion or so a year), then this corner will eventually collapse, and it will take many years (if not over a couple of decades like silver) for copper to regain its former highs.  That is just the historical experience of corners – nothing more.

Okay, that was a long quote – but I personally felt that the above paragraphs gave a very clear idea of where I stood on the commodity bull market.  Nearly five months later, commodity prices are lower across the board (with the exception of nickel), and while there should logically be some calm in both the energy markets and the metals market given the recent turbulence and hedge fund liquidation, prices are still generally too high (that also includes natural gas) for a long-term hold at this point.  For folks who are still long commodities, this “asset class” is now clearly in a cyclical (although perhaps short) bear market and should be sold on strength.  And for folks who want to get in on the long side for a short-term play, I urge you to stand pat for now – since there may be other hedge funds out there that have been long energy and which may also be in the midst of a liquidation phase.

The subject of commodities inevitably leads to a discussion of the “yen carry trade.”  In commentaries earlier this year, I had discussed the yen carry trade and its potential role in the rise of the high yielding currencies of the developed world (such as New Zealand and Iceland), as well as its potential role in the rise of commodities.  In light of market action over the last six months and in light of the latest “Financial Stability Report” from the IMF, this author now has much clearer view of the yen carry trade (or the lack thereof).

First of all, it is ludicrous to think that there has been no yen carry trade – given the low overnight borrowing rates and given the official policy of the Bank of Japan to maintain a relatively low Yen in order to export its way out of the country's economic doldrums.  The first modern Yen carry trade occurred in the late 1980s – when many traders borrowed Yen to “invest” in the much-higher yielding currencies that were participants of the ERM (European Monetary System) mechanism.  This pressure on the Yen was further compounded by the huge investments in the real estate market in U.S. at that time by Japanese investors.  When the Nikkei and the Japanese real estate market started a long decline in 1990, many Japanese investors were forced to repatriate their capital from overseas – thus marking the beginning of the end of the first modern Yen carry trade.  The Yen proceeded to rise nearly 20% in 1990, but that was only the beginning.  It rose another 6% in 1991 and then declined slightly in the first few months of 1992.  The first warning for the ultimate end of the Yen carry trade came in September 1992, when Great Britain was forced to exit the ERM mechanism (it proceeded to fall from US$2 to US$1.40 in the next three months).  While the Yen initially held on (and even declined), this was not to be – as Sweden followed with its own devaluation in November 1992 – followed by Spain, Portugal and Ireland.  By the end of 1992, Western Europe was severely weakened (as many countries that had chosen to stay within the ERM had to raise their interest rates severely in order to keep up with the rise in German interest rates following its reunification).  Speculative outflows started occurring in the beginning of 1993, and eventually turned into a torrent by the summer.  The first modern Yen carry trade was now over, and the next Yen carry trade would not occur until the summer of 1995.  From the beginning of 1993 when the Yen (100) traded at US$0.80, the Yen would eventually end up 50% higher at US$1.20 by the summer of 1995.

The second great Yen carry trade began in the summer of 1995 and it did not end until October 1998 – when the Yen ended its decline by rising 15% in a week!  Since this Yen carry trade should be familiar with most participants in the stock market (and is something we have discussed before), I would not go into further details here.

As for the current Yen carry trade, there is little evidence to believe that much of the borrowed Yen went into commodity speculation – as the decline of commodity prices in the last four months has generally not led to a higher Yen.  More likely, the typical profile of the latest Yen carry trade participant is as follows:

  1. A speculator who borrows or shorts Yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., UK, or countries in the Euro Zone.  The days of using this money to invest in higher-yielding countries in “peripheral” developed countries like Iceland and New Zealand has definitely ended – given the crash in both of these currencies earlier this year.

  2. A Japanese investor (e.g. a pension fund, a life insurer, or an individual investor) who converts his money from Yen to U.S. dollars (or the Euro or the Pound, etc.)  in order to invest in Treasuries or overseas real estate.  Note that this position is usually unhedged – which again puts further pressure on the Yen.

Quoting the IMF's “Financial Stability Report”:

The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors—particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1 percent of GDP.

There are also some indications that foreign investors borrowed yen to fund positions in higher-yielding currencies, but this evidence is more mixed and the magnitude of this form of the carry trade is less certain. Data from the Bank for International Settlements show that Japanese banks increased their net outward yen-denominated lending from $19 billion in 2004 to $87 billion in 2005. Japanese financial institutions probably also provided yen funding through derivatives transactions with offshore counterparties, and Japanese banks have “increased investing in alternative financial products, such as structured bonds, securitized products, hedge funds,” according to the Bank of Japan.

Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006 (see the third figure).

As mentioned in the first paragraph above, following is the figure showing the huge increase of Japanese inflows into both foreign bonds and foreign stocks since the beginning of 2005 (although it has abated somewhat recently):

Increase In Japanese Holdings of Foreign Assets Through Investment Trusts

And following is a chart showing the net Yen positions of noncommercial traders at the Chicago Mercantile Exchange, courtesy of the IMF.  Note that the short position on the Yen as held by noncommercial traders is at an extreme high.

Yen Positions of Noncommercial Traders at the Chicago Mercantile Exchange

So the $64 trillion question is this: When will the Yen carry trade end?  On a purchasing power parity basis, the Yen is undervalued against the U.S. Dollar, but massively undervalued against the Euro.  That being said, things can always get more extreme before reversing – especially when it comes to the financial markets.  Drawing a tentative up trend line from the previous lows in the Yen in early 1990, October 1998, and early 2002, and one gets a target range of approximately US$0.78 to US$0.82 (for every 100 Yen) before we see the Yen bottoming.  But in all likelihood, it will need some kind of trigger.  Just what is that trigger?  I will discuss more about this as we approach the US$0.78 to US$0.82 range and my preferred timeframe (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play starting January 1, 2007.  Historically, a goods & services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different – despite the prevalent optimism among the German government at this point.  Readers please stay tuned.

Signing off,

Henry To, CFA

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