From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!
--Old Scottish Prayer
Where the Wild Things Are
is a beloved children's book and now a beautiful movie. But in the
investment world there are really scary wild things lurking about in
the hidden recesses of the economic landscape. Today we look at one of
the unintended consequences of the Federal Reserve's low interest rate
For quite some time, I have been arguing that we are
faced with no good choices, not just in the US but in the entire
"developed" world. I see a low-growth, Muddle Through world over the
next years (with a double-dip recession just to liven things up).
However, that does not mean that we will lack for volatility. Things
could get volatile rather quickly. Let's quickly set the background.
It Is Not Just Japan
look at today's interest rate picture. Yesterday, we had the bizarre
occurrence of banks actually paying the government to hold their cash.
Three-month treasuries yield a miniscule 0.01% in interest. If you opt
to buy a one-year bill you get all of 0.26%. You can see the entire
at the graph of the yield curve below. It is as steep as we have seen
it in a long time. But that is almost the point. Banks are essentially
getting free money. If you are a banker and can't make money in this
environment, you need to quit and find meaningful employment.
that is part of the rationale that the Fed espouses with its low
interest rate regime. Not only does it allow banks to repair their
balance sheets, it also encourages investors to put money into riskier
assets in order to get some return on their investments. Over $260
billion has gone into bond funds this year, and just $2.6 billion into
stock funds. However, you have to balance that with the fact that some
$400 billion has left money market funds paying less than 0.2%. So
there is some movement to capture yield.
But is it just banks
that are getting cheap money? And is encouraging investors to find
riskier assets a sound policy? Maybe not.
The Euro-Yen Cross and the Dollar Carry Trade
wrote a great deal in the past few years about the strong correlation
of the euro-yen cross to stock markets all over the world in general.
(The euro-yen cross is the exchange rate of the euro and the Japanese
yen.) This was a proxy for the Japanese carry trade. The stock markets
of the world rose and fell in synchronization with the yen versus the
A currency carry trade is a strategy in which an investor
sells a certain currency with a relatively low interest rate and uses
the funds to purchase a different currency yielding a higher interest
rate. A trader using this strategy attempts to capture the difference
between the rates, which can often be substantial, depending on the
amount of leverage used.
The Japanese drove their rates down to
essentially zero in the 1990s. By early 2007, it was estimated that the
yen carry trade was over $1 trillion. But when the world credit crisis
hit, the world wanted dollars. They paid back the yen and bought
dollars, driving the yen higher and killing the yen carry trade. Who
wants to borrow in a currency that continues to rise, even if the costs
are low? And often, large leverage was used, so small movements in the
currency could destroy outsized amounts of capital.
there are some who are beginning to ask whether there is a dollar carry
trade. In the last nine months, the correlation between the dollar and
the stock market has gone to about 90%. If the dollar rises, the stock
markets and other risk assets tend to fall, and vice-versa. It would
appear that investors and funds are borrowing cheap dollars on a
short-term basis and investing in all sorts of risk assets. Not only
have stock markets risen, but so have high-yield bonds, commodities,
and so on.
We have seen the steepest rise in US stock markets
coming out of a recession since the end of the last world war. The
market is "discounting" a 5% GDP next year and a profit rebound beyond
anything in past experience. Depending on the quarter, operating
earnings are expected to rise by anywhere from 30-40%. P/E ratios are
back at 23, well above the 17 we saw in the summer of 2007 (I am using
4th quarter 2009 estimates so as to not have to take into account the
disastrous 4th quarter of last year.)
Worrying about a dollar
carry trade is not just a preoccupation of my friends Nouriel Roubini
or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:
"China's Liu Says U.S. Rates Cause Dollar Speculation
15 (Bloomberg) -- The decline of the dollar and decisions in the U.S.
not to raise interest rates have caused "huge" speculation in foreign
exchange trading and seriously affected global asset prices, said Liu
Mingkang, chairman of the China Banking Regulatory Commission."
continuous depreciation in the dollar, and the U.S. government's
indication, that in order to resume growth and maintain public
confidence, it basically won't raise interest rates for the coming 12
to 18 months, has led to massive dollar arbitrage speculation," he told
reporters in Beijing today at the International Finance Forum.
said this has 'seriously affected global asset prices, fuelled
speculation in stock and property markets, and created new, real and
insurmountable risks to the recovery of the global economy, especially
"His view echoes that of Donald
Tsang, the chief executive of Hong Kong, who said the Federal Reserve's
policy of keeping interest rates near zero is fueling a wave of
speculative capital that may cause the next global crisis."
scared and leaders should look out,' Tsang said in Singapore Nov. 13.
'America is doing exactly what Japan did last time,' he said, adding
that Japan's zero interest rate policy contributed to the 1997 Asian
financial crisis and U.S. mortgage meltdown."
It is not just
China. Brazil has moved to impose a tax (or tariff) on investment money
coming into the country on a shorter-term basis, as they are worried
about both a bubble in their markets and in their currency. Russia is
openly considering similar policies.
I have been doing a lot of
speaking in the last month. In almost every speech, I warn of the
significant imbalance in the dollar. I walk to the very end of the
stage to help illustrate that the world now has on a massive ABD trade.
By that I mean Anything But Dollars. Everyone is now on the same side
of the boat. They have borrowed dollars to buy other risk assets,
assuming that the dollar, like the yen in the glory days of the yen
carry trade, will continue to fall. Dollar bears are everywhere.
abound for why the dollar is a trash currency. It is Fed policy, or the
Obama administration's willingness to run massive deficits, or the
trade deficit or our health-care policy or (pick any number of issues).
But I wonder.
Global trade collapsed last year and well into this
year. Global trade was essentially done in dollars. If global trade is
down 20% or more, then there is less need for companies in various
countries to hold dollars and more need for local currency because of
the crisis. Thus, after a rush to safety in the credit crisis, there is
a rational selling of dollars by business.
at the above chart. Notice that the dollar is roughly where it was 20
years ago. And notice the recent jump during the credit crisis. We are
not even back to where we were before the crisis.
if world trade picks back up, as it appears to be doing? Admittedly, it
is not a robust recovery as yet, but it is rising. That means more need
for dollars. And dollars which are being borrowed (and probably
leveraged!) on the assumption the dollar will continue to fall.
I agree that, over time, the case for the dollar is not as good as I
would like. But in the meantime, we could have one very vicious dollar
rally, which would take equity markets down worldwide, along with other
risk assets. Why? Because it would be a major short squeeze.
just did a survey. It revealed that the bullish sentiment on stocks is
quite high and almost everyone hates US treasuries (graph courtesy of
David Rosenberg of Gluskin, Sheff)
sentiment gets too strong in one way or the other, it is usually
setting up the markets for a rally in the despised asset. Mr. Market
like to do whatever he can to cause the most pain to the largest number
I am not predicting a near-term crash or imminent
precipitous bear, although in this environment anything can happen. I
am merely noting that there is an imbalance in the system. The longer
this imbalance goes on, the more likely it is that it will end in
tears. And the irony is that a recovering world economy could be the
The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.
New York, London, and Switzerland
am going to hit the send button on what may be the shortest e-letter I
have ever done. The travel is catching up with me and I need some rest.
am looking forward to Thanksgiving next week. It may be my favorite
holiday. Family, friends, food, and football. My usual pattern is to
get up very early Thursday and start the prime slow-cooking, and then
turn to the side dishes. It will be no different this year. My brother
will bring the smoked turkeys, which he has down to an art form. And
then there are the over-the-top wines I was so graciously given this
past birthday by so many friends. I will bring a few of those bottles
The next weekend I am in New York for Festivus with the
crowd from Minyanville, and then I am home for over a month before I go
to London and Switzerland in late January. Then not much is currently
scheduled until April, although it always does seem to change. After
the recent hectic schedule (15 cities and even more speeches in just a
little over three weeks), I look forward to some home time.
wish those of you in the US the best of Thanksgivings, and the rest of
you a great week. And thanks for all the very kind words of late about
Tiffani. She seems to be doing better. She is due in a month, so she is
still moving slowly, but you can sense the excitement in her and Ryan.
I find it all very pleasant.
Your "there's no place like home" analyst,
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