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Henry To

Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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Liquidity and the Yen Carry Trade Redux

Dear Subscribers,

Before we start our commentary, I want to alert our readers to a couple of things. First of all, a new board has been set up in our MarketThoughts discussion forum. Titled "Mutual Funds, Hedge Funds, and ETFs," the board's purpose is to allow our readers to discuss the latest developments in the mutual fund, hedge fund, and ETF industry. Under our old organization, too many of these posts were getting "lost" in our "Market Commentary" board. Moreover, I also believe that there is an "untapped market" out there of potential posts, since many of our subscribers have a disproportionate interest in individual funds but who just have never posted since most of our posts did not revolve around this topic. Hopefully, this will change going forward.

Second of all, a friend of mine recently sent me a link containing Warren Buffett's old letters to shareholders from 1959 to 1969. These are a must-read. You can't find these letters anywhere else - not even on the Berkshire Hathaway website.

Now, let us continue the rest of our commentary. First of all, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As the bulls continue to have a "field day" with the bears (the Dow Industrials, the Dow Transports, and the S&P 500 all closed at all-time highs for the week), there are now storm clouds arriving on the horizon. Besides the many things that I have previously discussed - such as weakening relative strength of the American Exchange Brokers/Dealers Index, rising bond yields, and the fact that many of the popular bear commentators have now "capitulated" to the bull side - I have also mentioned that liquidity conditions have been deteriorating. That was discussed in our mid-week commentaries during the last couple of weeks, and I would again like to discuss this in today's commentary.

I would like to begin this discussion by giving our readers an update of our MarketThoughts "Excess M" (MEM) indicator. This is an indicator that we have not discussed for a while now, but I still believe it is a relevant indicator, even in today's globalized world of financial flows. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and ultimately, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks, hedge funds, private equity funds, and foreign central banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly. Instead of using M-3, we are now using a monetary indicator that most closely resembles the usefulness of M-3 - that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy. We went back and found one measurement that is very close - that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a weekly chart showing our "new: MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

Since our last discussion revolving around our MEM indicator, it has continued to decline - signaling a further deterioration of prime liquidity vs. "secondary" liquidity. That is, while foreign central banks such as the People's Bank of China and the Reserve Bank of India, hedge funds, and commercial banks are still busy creating liquidity, the Federal Reserve itself has continued to remove liquidity from the global financial system. This is evident by the dismal 1.6% growth in the St. Louis Adjusted Monetary base over the last 12 months. At this point (similar to the 1995 to 1998 period), the world is being "held ransom" by both the Bank of Japan, the Japanese Ministry of Finance, and the Japanese retail investor, as these parties are now playing the role of "liquidity provider of last resort" in the form of the Yen carry trade. Since Japan runs a current account surplus, however, Japan is thus not a natural exporter of their currency (unlike the U.S.). Moreover, the Yen carry trade - by any measure - is now way, way, overstretched. That is - if this continues - at some point, there would be a liquidity squeeze in Yen - not unsimilar to what occurred during the Fall of 1998 (when the Yen appreciated over 10% in an hour). Readers should continue to both watch the level of the Yen and the actions of the Federal Reserve for signs of a continued decline in world liquidity.

Just how overstretched is the Yen carry trade, you may ask? While Yen carry trade data is very difficult to come by, the Bank for International Settlements (the BIS) does make a good attempt at gathering it, since it publishes data of the amount of foreign currency derivatives outstanding on a semi-annual basis, from both a notional standpoint and a market value standpoint. Since looking at notional value is next to useless, we have chosen to look at the total market value of the Yen currency derivatives instead. Following is a chart showing the total amount of Yen currency derivatives outstanding from June 1998 to December 2006 broken down by instrument:

Note that the December 2006 data was just released last month. More importantly, the total amount of Yen currency derivatives outstanding just spiked higher in the last six months of 2006, and has now surpassed the December 2001 highs and is now at its highest level since December 1998. The above chart is a good signal of how much of the Yen carry trade is taking place in the derivative markets - and the answer is: Quite a bit. Moreover, it is important to remember that a carry trade only works in a low volatility environment, and given that the implied volatility of Yen options just touched an all-time low a couple of weeks ago, my guess is that the environment will be less conducive to all types of carry trades going forward, including the Yen carry trade.

Also note that the above data is now more than five months old - and given the weakness of the Yen over the last five months against virtually all major currencies (including the US$), there is good reason to believe that the short position of the Yen carry trade has now reached an all-time high. Coupled with the fact that the Fed is still taking away primary liquidity from the financial system, my guess is that this will be a tough summer for the bulls - not just stocks but on commodities and real estate as well.

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