September 01, 2009
Posted by: Dave Bhagat
"Beware of geeks bearing formulas."
- Warren Buffett
Ever since the financial crisis began in the summer of 2007, and
especially since Lehman Brothers failed in September last year, the
doom and gloom folks have been warning that the United States could
face a future similar to Japan's lost decade. There were several
similarities at the outset; real estate and banks were a large part
of the problem, rates were cut dramatically and quantitative easing
was used in both cases. However, ever since the stock market began
to rally in March this year, that sort of talk has been replaced by
a far more optimistic view of our future prospects. Time will tell
whether such optimism is warranted.
One similarity that still exists today is the impact on short-term
rates. Dollar rates have fallen steadily; it began with the Fed
cutting official rates, followed by falling market rates as the
credit crunch eased and spreads compressed. As of last Friday,
three month USD LIBOR was 0.3475 percent, about 4 basis points
lower than the equivalent JPY LIBOR - the last time this happened
was 16 years go.
In addition, as rates have fallen, the dollar has begun to react
to market forces much like the JPY has done ever since the Bank of
Japan began quantitative easing in 2001.
The JPY lost ground steadily versus most currencies from 2001
until the beginning of the financial crisis in 2007, as money
poured out of JPY and into risky assets and markets and speculators
invested in "carry trades." In a simple version of the carry trade,
a speculator would borrow a low interest rate currency like the
JPY, sell JPY and buy a high yielding currency (AUD, NZD, BRL, GBP
and others were commonly the currencies of choice). By doing this,
they would earn the "spread" between a low cost of borrowing and a
higher yielding investment. For most of those years, they often
were rewarded by capital appreciation as well, as most of those
currencies strengthened versus the JPY. Once markets began to fall
and risk aversion set in, many of these trades were unwound and the
JPY strengthened precipitously on the crosses, causing large losses
for those in carry trades.
That pattern continues today - when risk appetite is on the rise,
equities, commodities, risky assets and higher yielding currencies
rise and the USD and JPY fall. The reverse is also true - when
markets fall, the USD and JPY benefit. Despite the fact that USD
and JPY rates are virtually identical, the JPY tends to outperform
even the USD in times of risk aversion, perhaps indicating that for
now it remains the "true" funding currency in carry trades.
Assuming dollar rates stay low for some time, as appears likely,
will the dollar become another funding currency like the JPY? While
that appears to be the case for now, I don't see that continuing
for more than a few months, for a few reasons. Some have to do with
the future of carry trades as a speculative vehicle, while others
relate to basic differences between the situation facing Japan then
and the U.S. now.
Carry trades are not as prevalent today, as speculators are less
willing to make leveraged currency bets. Many of the carry trades
were created and sold by hedge funds and investment houses to
speculators; as their ranks have thinned and as margin trading
availability and leverage has declined, so has the volume of these
transactions. In addition, option volatility remains somewhat
elevated compared to a few years ago, raising the cost of hedging
these trades, which used to be a fairly common practice.
Turning now to the difference between our situation and Japan's a
few years ago, capital flows play a significant role. In the early
part of this decade, a major factor contributing to JPY weakness
other than carry trades was an outflow of domestic Japanese savings
to other markets. With very little foreign capital flowing into
Japan to offset it, downward pressure on the JPY increased and made
speculators far more sanguine about establishing short JPY
positions. Flows into and out of the USD are far larger and more
complex, consequently more difficult to predict and at least for
now, far more supportive of the USD, which raises the risks of
being short the USD.
Finally, it was obvious to most market participants that Japan had
very little chance of a sharp recovery in the early part of this
decade. Confidence was low, the presence of zombie banks curtailed
lending, the real estate slump continues even today, while the
stock market at its peak in 2007 remained about 20 percent below
the 1995 peak. As of last week, it is over 50 percent below the
1995 peak. For our economy, there is far greater uncertainty about
the future trajectory of the economy. While we may in fact languish
for a year or two with little or no economic growth, there is a
chance that growth could rebound more strongly. That would result
in rate hikes and a stronger currency. The mere specter of
two-sided risk will keep most speculators at bay.
In conclusion, while the USD may behave like the JPY currently,
this is probably not going to last. In the near term, it is likely
to remain under pressure when times are good and appreciate when
risk aversion rears its ugly head. Over time, however, it will
begin to react to the fortunes of our economy and in particular to
the likelihood of the Fed raising rates. Keep an eye on the
employment situation; when our economy starts producing jobs, it
may be time to load up on dollars, especially versus the JPY.
The following excerpt will be included in your message.
Just Another Funding Currency?October 22, 2012 Posted by: Dave Bhagat
"Beware of geeks bearing formulas."
- Warren Buffett
Ever since the financial crisis began in the summer of 2007, andespecially since Lehman Brothers failed in September last year, thedoom and gloom folks have been warning that the United States couldface a future similar to Japan's lost decade. There were severalsimilarities at the outset; real estate and banks were a large partof the problem, rates were cut dramatically and quantitative easingwas used in both cases. However, ever since the stock market beganto rally in March this year, that sort of talk has been replaced bya far more optimistic view of our future prospects. Time will tellwhether such optimism is warranted.
One similarity that still exists today is the impact on short-termrates. Dollar rates have fallen steadily; it began with the Fedcutting official rates, followed by falling market rates as thecredit crunch eased and spreads compressed. As of last Friday,three month USD LIBOR was 0.3475 percent, about 4 basis pointslower than the equivalent JPY LIBOR - the last time this happenedwas 16 years go.
In addition, as rates have fallen, the dollar has begun to reactto market...Read More