R.I.P, The Yen Carry Trade

Poor Ben. The real culprit is one Mr. Fukui, who is the Governor of the Bank of Japan. (Do not ask me how to pronounce that name.) While central bankers everywhere are in a struggle to prove their manliness by being harder on inflation than their peers, Mr. Fukui has shown to be the clear cut champion. They have taken massive amounts of liquidity out of the Japanese system in the past few months.

George Soros, commenting last week, brought home the point:

"I think we are in a situation where almost all the asset classes will be under pressure or are under pressure and the main reason for that is the reduction in liquidity. What people do not realize is that the Japanese Central Bank has withdrawn something over $200 billion worth of excess liquidity from Japanese banks. Now that money was not put to work in Japan because there was no room for it, a lot of that went abroad, went into emerging markets, there was a so-called carry trade and it is not that suddenly people are risk averse. It is really that liquidity has been drawn out of the market and that is affecting emerging markets."

$200 billion in a global economy may not sound like a lot. But remember this was money in fractional reserve banks. They could easily multiply it several times. Pretty soon we could be talking a trillion dollars. Much of it went into providing cheap liquidity to global hedge funds and aggressive investors and banks. Thus, as the leverage went away, these groups started liquidating their very profitable emerging market trades, their commodity trades, and so forth. Everything began to go down at once. Markets that had not been historically correlated all of a sudden went down in tandem to the drumbeats of margin clerks everywhere.

To get an idea of how seriously the Bank of Japan has reduced liquidity, let's look at the following chart from my friends at GaveKal.





There have been three large run-ups in the Japanese monetary base in the last 30 years. Not so coincidentally, there were three large periods of asset inflations which accompanied them. When the Bank of Japan began to tighten, we had resulting deflation of those assets. As I quoted GaveKal last April:

"Looking at the past thirty-five years, we find that the Japanese monetary base has been allowed to double over short periods (i.e.: less than three years) three times. Each time, it led to massive bull markets (real estate, share prices, commodities, gold, etc...), followed, some time after the expansion of Japan's money supply was over, by a serious market downturn. Will this time prove any different? So far, it has."

That was at the end of April. At the end of June we can see that it has not been any different. World stock markets have dropped precipitously along with commodity prices.

For several years, speculators have been able to get very low interest rate money in a currency that was purposely being held down. It doesn't get any better than that. Low cost money encouraged speculation in every corner of the investment world. Not just stocks and commodities, but high yield and emerging market debt. The yen carry trade fueled the investment world.

Now Japan has said not only are we going to take massive amounts of money supply from the world, we are going to raise rates and allow the yen to rise. All that "free" money investors and businesses around the world borrowed is going away. It is going to become far less than free. By-by carry trade. Fukui indeed.

We are now going to look at three charts from GaveKal's latest quarterly. They tell a chilling story.

"In our world, two actors can create money out of thin air: the central banks, and the commercial banks. Over the past year, the world's central banks have been busy draining liquidity from the system.




"While the central banks were busy taking money away, the commercial banks were happy to multiply whatever money they had at an ever faster pace. This is now changing; with the increase in volatility, commercial banks are pulling back. As Mark Twain once said, commercial banks lend you an umbrella, then take it away once it is raining."

(Velocity in the next chart is a way to measure commercial lending growth.)




"The divergence between the action of central banks and the action of commercial banks recently reached unprecedented levels. In the past (1997, 2000), once the commercial banks got a whiff of the message the central banks were attempting to convey, they changed their behavior rapidly, and uniformly. Will we now witness a sharp snapback as we did in 1997 and 2000?"

OK, remember they asked the question in April whether Japan taking liquidity off the table would be different this time? It wasn't. And my bet is that commercial banks will also start the process of taking liquidity off the table as well. Loan committees are going to tighten their requirements on all types of lending. Get used to it.

Between the central banks of the world almost universally tightening, commercial banks poised to tighten and the US housing market looking like it is going to slow as interest rates rise, it is very likely the US economy is going to slow down in the last half of the year. The question is, "How much?"

I do not think we will be in an actual recession by the end of the year. But a recession is not out of the question for 2007. If the Fed does not have to go too far (and 5.5% may be too far given the other conditions in the world), then we could see a slowdown on the order of what we saw in the mid-90's. We will have to watch the yield curve and other indicators.

In any event, whether it is slowdown or recession, I think investing in the broad stock market is particularly risky. If you are good at picking stocks and know the companies you are investing in, that is one thing. But most readers invest in mutual funds and broadly diversified stock portfolios. Bluntly, I think there is some real risk to the downside.

And if the US economy slows down, so will the housing market and so will the US consumer. That will be a drag on the world economy and world growth in consumption. If the world slows down too much, you could see oil drop back into the $50's or even $40s