Yen Carry Trade Over - USD Heavily Shorted

All is good.
Equities rallying furiously.
Recession is over.

We are all OK correct?
Not Quite.

Has anybody noticed that the Yen carry trade is over? A trade that stated in late 2003 and ended in mid 2007. This was a highly profitable trade that appreciated over 30% in capital and could have earned upwards of 7% a year on the interest rate spread alone. At the trade’s height from mid-2005 until the summer of 2007 the trajectory of yen crosses rose with barely a correction. What am I saying? These type of trades are long term strategic trades that are difficult to unwind and once they start to unwind are extremely painful on all market participants.

The USD is now the primary funding currency for almost all financial derivatives globally,because of its low financing rate. If the USD gets stronger, Houston - We have a problem!

The reason we have a USD carry trade is courtesy of Ben Bernanke and his printing press. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely.

The reason global markets have a problem if (Big If) the USD appreciates from here is simply. Just think of the turbulence that would be unleashed by a sudden 5%-10% rise of USD across the board? Most traders have shorted the USD, then borrowed those shorted USD, and then used those shorted USD funds to finance other trades in other currencies. Interest rate swaps, over-night swaps, and many cross currency transactions that were leveraged using borrowed dollars can get crushed when the funding currency rate appreciates in value. With untold numbers of traders around the globe on the losing side of such a trade, it can make AIG and Lehman feel like a casual Sunday walk in the park. This is also a reason why global equities have been so strong. The risk trade (Long USD) has been unwinding, and unwinding for a reason. If global equities fall out of bed, many participants will head for safety (USD), totally blowing out the USD carry trade. This carry trade is financing all type of transactions around the globe, from gold bars, WTI Crude, and foreign government bonds. When global equities fall, there is going to be major carnage from commodities to debt instruments. Many foreigners have shorted the USD to buy US Equities like Apple, GE, GS, and Google just to name a few. I am trying to find out what the exact number of shorted USD is at the moment, but that type of data is just not available. This is why when a currency turns suddenly, the magnitude of the unwinding is often a surprise, and a surprise to the downside.

When the Yen was the primary source for world wide funding, it made the BOJ job of raising rates next to impossible. This is similar to what is happening in our country. Its not that the Fed wants rates at near zero. It has virtually no choice but to keep at near zero. In fact the Taylor rule is stating the a -7% is needed just to get inflation back. Japan has their lost decade in the 90's. We will have ours starting in 2010. Low rates never spurred Japans economy, why would it spur ours? Its just not going to happen with the massive credit contraction the US is going through.

tradersutra.blogspot.com/2009/09/bank-credit-m3-money-supply-keeps.html

Japan never made their banks accountable for all of the bad lending that had taken place, they just kept kicked the can down the road, twenty years later, they are still kicking. Banks were kept alive with government aid and falling companies were supported by bank loans and subsidies. Economic growth ground to a halt in Japan. Today its 100% Japan redux in the USA.

From 1995 onward the main Japanese interest rate set by the BOJ was never higher than 0.5%. But the extremely low rates did not spur economic growth. The zero rate policy which the bank began in 2001 to counter price deflation and foster economic activity accomplished neither goal. The only reason the export dominated Japanese economy got somewhat out of their doldrums was the growth of China/India. When those economies corrected, Japan was again trapped. In effect, fifteen years of massive government spending and little economic reform has only succeeded in raising the Japanese debt level to the highest in the industrial world without building a solid domestic base of consumption.

Obviously the US Economy is totally different then Japan's. We are an import economy. We don't have the yet demographic challenges that Japan has. But like Japan it all consumption based. Like Japan, US is highly leveraged to real estate. The Federal Reserve response to the sub prime housing problem began two years ago in September 2007 when it cut rates 0.5%. Since then the Fed has taken US rates effectively to zero and supplied enormous amounts of liquidity to the economy, initially to stave off economic collapse and subsequently to secure economic growth, but so far other then total out right government nationalization of all that is holy, how are we going to get normal organic growth back into the economy?

So far many are correct in shorting the USD. Deficits are widening faster than US officials can measure. Debt/Treasury issuance plans are increasing. The US economy still has headwinds. Most importantly the Federal Reserve is still shoveling liquidity into markets via Quantitative Easing and short rates will stay low for at least throughout 2010. The dollar will stay weak for the foreseeable future but too many people are in the same trade, and time to time there will be turbulence. The consequences of the weak dollar/ultra low rate policy is just setting us up for a much larger meltdown.