Disconnecting the Dots

Risk is selling for too cheap and the Carry Trade is the culprit. These are thoughts that the world most succesful investor seems to agree with but somehow it always gets left off the major highlights of his remarks.

In the market there is a price for everything. For every public company, for every commodity, for every currency. There are even prices for insurance on your portfolio and on the price of risk. The price is usually right. After all they’re scrutinized and evaluated by thousands of analysts and millions of speculators daily.

There are many different types of buyers. Many are there every day, not looking for good value but just something they can sell 10 minutes later at a higher price. Some only show up only once in a while, usually when they hear there’s some sale or issues selling at bargain prices.

Risk Undervalued
But every once in a while, the market as a whole gets it wrong. The 10-minute buyers offer unbelievable bargains for the value-savvy costumers.


In this light, Risk too has a price. You wouldn’t buy hurricane insurance in Kansas, would you? Of course not! But if a hurricane were to show up for all unpractical reasons many home owners would face a major loss of capital. You can afford the risk since your premiums wouldn’t pay off such a far margin of error.

But how about not buying insurance in South Miami because its out of season? That sounds ridiculous. But this seems to be the mistake many investors are making. They are selling risk out of season.

This is demonstrated by the low interest rates seen worldwide. True, they have been rising, but has this essentially performed its duty?

The Carry Trade
Japan has had it tough they had a wonderful economy doing wonderful things, the share market flourished and housing prices boomed. But, then came the inevitable bust that the frenzied public always seem to count as discounted. Japan and everything associated with it tanked.

Just a few years later we have the U.S. and the western world amid such a similar predicament. With the Dow soaring to new highs and a strong economy there wasn’t a dark cloud in the sky.

But then came the moment of transition. But we American’s are so much smarter than the Japanese. After all its been over 70 years since the last depression. So how do we prevent it from happening again? Offer the people what those in the depression lacked most – Cash. The Fed slashed interest rates to a mere 1% and threw cash piles out to the masses.

But it wasn’t just the Federal Reserve who was helping along. Japan at the time was offering a ZIRP or a zero-interest-rate policy. This meant that the government was practically begging for people to take its money, usury aside.

This being the case, even after the Fed began hiking rates investors and companies still found a way to cash in on yesterday’s price of interest. Borrow in Yen. This following later became widely known as the Yen Carry Trade. Yen were purchased on zero interest charges and swapped for higher yielding treasuries such as the U.S., Australian and New Zealand.

Here is what the market is discounting. Eventually, this moat is going to narrow. As a matter of fact this has already begun. Once it begins and the spread becomes less profitable the whole house of cards will collapse no different than the stocks that were selling for 50 times earnings in the past. You can only bet on a phenomenon while its still in motion. Once it stops, and every moving thing that is propelled by nothing more than limited resources does, the game is up.

In an age of knowledge every man and woman, regardless of whether or not they ever stepped into a course on economics has become yen-carry-trading, Chinese-stock-betting maniacs.

A Life Savor for a Dollar
This is what is holding up the U.S. economy. J
apan is supplying it with credit, allowing it to borrow and spend as much as it needs to survive. We then spend this money is low-cost-producing nations such as China and Japan. They in turn reinvest those funds back into U.S. Treasuries benefiting from the interest we will borrow from them to pay them with.

Sounds ridiculous, doesn’t it? But here’s why they continue to do it. If they lose the U.S. they lose their best costumer. As long as he comes in every day and buys half the store, there is no reason to deny him credit.

But Japan is paying out more to keep its best costumer than would be worth to forgo the debt. Real rates in Japan are negative. This means that it far more sensible for people to hold consumer goods which are increasing at the rate of inflation than to hoard cash that compounds at a mere 1/2 percent.

Conclusion
A higher yen as a result of rising inflation fears and higher wages will mean more inflow to economy, raising U.S. rates and consumer prices in the process. This translates as destruction – Hiroshima-style – for the Dollar and the American economy. We will once again face the deflation side of the equation that the Japanese know all too well. The spread between physical goods and its immaterial derivatives will narrow.

You can speculate on a rising Yen, a weaker dollar, a narrower spread for rates on interest and credit, do not however discount what you may not know.

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