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April 11, 2004

Hong Kong Fighter Pigs, Part 3
by John Mackenzie

By borrowing funds in a foreign market and using these funds to purchase an offsetting position in fixed income securities in a domestic market, traders attempt to capture the spread advantage of low borrowing costs better known as the "Carry Trade."

Essentially, these traders earn a riskless return if the exchange rate does not move adversely against them. The uncertainty of exchange rates is not contained by "Fixed" or "Floating" rates of exchange as "Market Forces" tend to adjust "Price" to its underlying "Value" over time.

I would suggest these market forces affecting the global financial system are not within in the context of conventional economic text, nor are they being accurately represented. The interventionist policies of Central Banks are creating far too many anomalies to accurately portray the systemic risks that surround the broad markets.

Factors that should present predictable cause and effect relationships have been muted, further compounding risks and sending improper signals to the global financial system.

But why?

The Bank of Japan has created massive quantities of Yen out of thin air. In turn these Yen have been used to purchase U.S. Dollars and Dollar Instruments. These inflows have helped kick-start our fabled recovery. It has allowed the Federal Reserve to lower its Federal Funds Rate precipitously, in effect compounding the effects of these very inflows.

This cause has resulted in multiple effect "Echo Bubbles": Bonds, Equities and Real Estate have all exceeded economic and financial sense, common or otherwise.

It is important that we understand the underlying "strength" has been Yen created out of thin air. These inflows began to increase in dramatic fashion as the "New Economy" paradigm turned south for the Kondratieff Winter thereby delaying the ultimate day of financial reckoning.

Is capital truly flowing out of Japan? No, it is not.

Investors have been keenly focused upon Japan's weakened Banking System hoping the value of the Yen would continue to deteriorate. This view is widely held as the Forex bets have continued to compound on the simple premise money would flow out of Japan.

Market forces have begun to align against the Carry Trade as the Yen's price began to correspond more closely with its underlying value.

How can this be, would it not be logical to assume the very opposite?

In my opinion it would not as long as the gains associated with the carry trade were to offset the trade surplus and cost of printing Yen out of thin air.

Further exacerbating the systemic risks to this trade is our own Central Bank's reckless policies. Will Japan keep pace with its Yen debasement thereby allowing those engaged in the Carry Trade to unwind their collective bets with cheaper Yen?

Is this why Japan continues to debase its currency in the light of day and can this cannibalization continue until these risks are unwound?

No one knows for certain, but it appears to be a game fast afoot. It's a compelling drama given it's the underlying basis for our "Economic Recovery."

I suspect the BOJ will continue in its reckless ways, but slowly begin to sell its massive amount of U.S. Treasury Bills, Notes and Bonds and begin to purchase Yen in order to preserve what remains of their economy. At some point consumers will be forced to stop consuming, save and service/retire debts.

The alternative is further debt through escalating asset values already beyond absurd levels in their price to value relationship.

This will have a broad impact on our foreign financiers, namely Japan.

Perhaps this is why Japanese Finance Minister Tanigaki stated he would "cautiously consider the positioning gold within foreign reserves . . . "

How important is the loss of U.S. Dollar Based Foreign Reserves to Japan?

Not very in my opinion, and if you are going to succeed at tilting the table in your economic favor, you choose an exit from the global financial system's double bind and act accordingly.

The warning shots have been fired several times. They have gone largely ignored.

And therein lies the risk of when and not if it unfolds.

Just how the Gold Carry Trade responds to these immense pressures will be compelling to witness.

What goes around does eventually come around... full circle.

The "Interventionist" din continues to rise or as Shakespeare once said, "me thinks the lady doth protest too much."

John Mackenzie

John Mackenzie manages private capital - Email: m2jrmfl@bellsouth.net

Copyright © 2004-2005 John Mackenzie

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