BoJ sneezes, rest of the world catches cold

It seems that all the Yen carry trade really accomplishes is a further "bubbleization" of the world economy. Some hedge funds will reap huge profits and others will fail disastrously. Some rich investors will get a little richer and some will lose out. Some pension funds will have huge surpluses and some will have to resort to plan "B" to fund retirements.

The term “carry trade” without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend high-yielding ones. The risk of carry trades is that foreign exchange rates will change, and the investor will have to pay back now more expensive currency with less valuable currency.

In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the target currency, because investors sell what they have borrowed, and convert it into other currencies.

For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into $$ and buys a bond for the equivalent amount. Assuming the bond pays 4.5% and the Japanese interest rate is set at 0%, the trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Leverage can make this type of trade very profitable. If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (4.5% * 10). However, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Furthermore, because of the leverage, small movements in exchange rates can magnify these losses immensely unless hedged appropriately.

Meanwhile, emerging economies struggle to survive the torrent of carry trade money and markets become more volatile. As of early 2007, almost a trillion dollar is locked into Yen carry trade positions.

There is an enduring idea that if the "the market" sets the price of currencies, equities, commodities, and other assets, then this is somehow better. The market knows best. But if "the market" is dominated by hedge funds with easy access to cheap money, this can be more destabilizing than beneficial.

Tim Iacono submits Much of the blame for last week's shellacking of financial markets around the world has been attributed to the "unwinding" of the Yen carry trade. That is, when hedge funds and other financial institutions closed out investment positions funded by money borrowed at low rates of interest from Japan.

After the Bank of Japan raised interest rates a few weeks back, the Yen strengthened and the higher borrowing cost combined with a narrowing exchange rate differential began to eat into investors' gains.

Spurred by a recession warning from Alan Greenspan and the plunge in the Shanghai Composite index last Tuesday, carry trade profits were promptly taken, resulting in the sale of stocks, commodities, currencies, probably a few paintings, and who knows what else.

This distorts the entire exchange rate picture and only benefits hedge fund managers and their investors. There is no discernible improvement in the "allocation of capital" - it's just "asset shuffling".

Down went the investors in the poor third world, thanks to smart money movements initiated by the Hedge Fund managers. Well, obviously there are some lessons here for everyone.

You can find the full report here.

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Rule No.1 for Equity Analysts – CONFUSE !

I had always maintained that best time to invest in a stock is when no analyst is talking about it. The one thing I look for is to make sure that it generates adequate cash from its operations ( to support its financing & Investment activities without adding in too much of fresh debt ) and makes it regularly to the dividend list.

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My portfolio modeled after this theory is still in good shape, so I am actually walking my talk.

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I had noted that a stock should've rallied 100% over one week to draw the first analyst's attention to it. Soon all of them would be talking it up. That’s precisely when I exit it. This theory of mine is well tested and I recommend it to one and all.

Hence I am qualified to spurn those late bloomers.

Look at this. Till the week before last, when Asian markets were performing well, all these analysts were doing an encore “this is an extended bull market – stay long”. Now since last week, may be because of Yen carry trade unwinding or general fatigue associated with any long bull market, when investors booked some profit the market suckers have turned bearish. And how much at that ? Just stopping short of saying “Apocalypse NOW” ! Full report published in Economic Times today is here.

According to this report which quotes some analysts, things seem to be changing fast considering that the risk appetite for emerging equities has declined. “Even from these levels, there is more possibility of a downside than an upside,” says one of the top three FIIs with a large investment portfolio in India and other emerging markets.

It even goes to say “The depth of the Indian market has been questioned by many FIIs. Even though the Indian equity market has seen a correction in line with other emerging markets, the spiralling effect is scary. Part of the reason is because small investors, who are more like speculators, invest directly into the equity market”.

Were they not scary earlier ? Why do you suddenly feel cold after it had declined by 20% ? Where were you when new listings ( construction, infrastructure stories) with no track record were offering 50% plus returns ? Now tell me, how much does your wife trust your judgement ?

Yet taking a contrarian view, there are some who believe a further correction would be the right time to buy the ‘India story’. A Morgan Stanley analyst, based out of New York, states: “My view remains the same as reported in our research note. This is an extended bull market, and a correction is long overdue. So, we would buy after a 10-12% correction in the Indian equity market.”

What is an investor to make of it ? I use my own judgement which is to buy more of good stories with every decline. Tell me, would you buy these morons ?

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