-- Posted Tuesday, 6 June 2006 | Digg This Article
The following article grew out of a question from a friend who was kind enough to forward me one of the many recent articles making the rounds in cyberspace detailing the effects of a possible yen carry trade unwinding. I disagreed with some of the conclusions of the author and decided that it might not be a bad idea to offer a different perspective on this topic and perhaps facilitate some further thinking through of this matter. I ask the reader’s pardon as the flow of the article might seem a bit choppy at times but the original took the form of a simple email response and was modified to allow for publication in a more widespread form.
First of all - The author would need to explain how he comes up with the scenario of falling interest rates in the US with a carry trade unwinding. I would strongly disagree with that conclusion.
What those who keep espousing a doomsday scenario for commodities and gold due to a potential carry trade unwinding keep forgetting is the actual process of the original trade and the currency dynamics involved. Let’s examine that.
A hedge fund goes to Japan and borrows Yen at a ridiculously cheap rate. In order to do anything with it, they have to then sell the yen and buy dollars so as to be able to purchase dollar backed Treasury paper or commodities sold in dollar terms on the world market. That has the effect of putting a bid under the dollar since it creates dollar demand and tends to weaken the yen (yen are sold or exchanged for dollars). As the trades are reversed, these assets are sold. The yen loans must be paid off in yen terms and thus dollars must be sold and exchanged for yen. This has the effect of dropping the dollar and pushing up the yen.
It is the sale of those dollar based assets that would give us an additional supply of dollars and a new demand for yen. Why? Because the yen loans must be repaid with yen not dollars. To get yen to repay a loan in yen one would have to exchange your dollars for yen. That is why the currency markets are also referred to as the FOREX markets (Foreign Exchange markets). Dollars are exchanged or sold for yen. Result – a weaker dollar and a rising yen.
Keep in mind that it was the buying of these US dollar backed instruments, most notably Treasuries of all duration but especially the long end, that gave us the famous “conundrum” of Greenspan. Players borrowed yen for next to nothing, sold those yen for dollars and used those same dollars to then purchase US Treasuries. As the trade is unwound, all those Treasuries are sold adding additional supply onto the market. More supply without a corresponding rise in demand means prices of Treasuries would fall. Falling Treasuries have the effect of PUSHING UP INTEREST RATES, NOT LOWERING THEM.
Additionally, a rising yen then impacts the reserves of Asian Central Banks since all Asian currencies would rise in tandem with the yen particularly if the Chinese let their currency float upward. That of course means that the value of the dollar is falling against the currencies of the Asian region. What do you think Asian Central Banks are going to do as they watch their humongous amount of dollar based reserves losing value? Buy more Treasuries? Of course not! They will buy less and begin to sell the ones that they hold. To a certain extent we are already seeing that take place in Japan according to the most recent TIC reports. This occurrence has the effect of removing a GIGANTIC source of US Treasury demand from Asia which does two things.
First, it serves to lower demand for dollars further knocking the props out under the dollar.
Secondly, it has the effect of further pushing interest rates even higher and pushing the dollar even lower in a sort of vicious feedback loop.
It will also show up in the TIC report and will rightly be viewed as dollar negative which will further reinforce the process.
A falling dollar is not gold bearish – period!
Additionally, those who run around crying the sky is falling when it comes to commodities make the fatal mistake of believing that the rally in commodity prices is due entirely to speculative demand from carry trade players. Not so. There is real physical demand for these commodities that is not going to disappear. Copper prices did not rise to $4.00 pound simply because a bunch of hedge funds decided to play the carry trade game with copper. It rose to these levels because FIRST OF ALL, there was a real shortage of the red metal. Stocks at the LME, Comex and in Shanghai continued to drop and end users simply could not get the stuff. Ditto for many of the other commodities out there such as rhodium, indium, moly, zinc, etc. This demand was indicated by the severe backwardation that existed in many of those markets which is a point that my friend Antal Fekete has been making recently when it comes to understanding market structure. That base metal demand is not going to go away anytime soon. Unless these guys advocating a collapse in the commodity sector can make a case for a reversal in the process of modernization in China, India, Asia, etc. then they are barking up the wrong tree in my opinion. While some sort of unforeseen economic shock in the Asian basin could slow commodity demand from that region, is not going to eliminate that new and vibrant source of demand. Modernization is not some flash in the pan occurrence but rather a huge macroeconomic shift with long term implications.
Besides, many folks tend to forget that the stronger these Asian currencies become, the cheaper dollar-priced commodities become in Asian currency terms. This allows them to buy more for the same price. Talk about a deal! How this phenomenon can be supposed to hurt demand for commodities is somewhat of a mystery to me.
Lastly, and more importantly for gold – Central Bank demand for gold is going to increase as new mine supply continues to fall. How do we know that? Simple – brain trusts from China have already recommended that China move to diversify its reserves and move a certain portion of them into gold. Russia has been doing the same and continues to advocate more movement in this direction. The more the fate of the dollar becomes suspect, the more this sort of thinking will find acceptance in official sector circles.
Keep in mind that mistrust of paper assets always feeds money into gold. With the US stock market teetering on a precipice, how many foreigners are going to feel comfortable buying US stocks? It was demand for US stocks during the mid to late 1990’s that allowed former Secretary to boast about a “strong dollar” policy. Without getting into the charade that was played with gold to reinforce that policy, one cannot have a “strong dollar” policy by simply announcing it. There has to be a legitimate source of demand for dollars from abroad to contribute to such a policy. During the bull market in stocks in the late 1990’s, that was easy. Pulling off the same stunt this time around with a swooning stock market is an altogether different game. Given the current technical posture of the US Stock Market, It takes quite a vivid imagination to picture a scenario where foreigners will be tripping over one another to plow their savings into the US stock market that has long been overdue for a serious downside correction. That will only further serve to decrease demand for dollars.
Now consider the fact that the world is awash in dollars – foreigners sit and observe the dollar losing value. They then prudently desire to reduce their supply of dollar backed assets. What are they going to buy with those US dollars to get rid of them? They cannot buy US hard assets such as oil companies (think Unocal) or ports (think Dubai Port Deal) since the political climate in Washington prohibits that. If they are not going to buy US stocks, if they are not going to buy US Treasuries but rather reduce their rate of buying those, if they cannot buy US hard assets such as companies, etc. then what is left? Answer - they will buy commodities as a store of wealth or sources of such commodities and that will include gold.
They will look to take those surplus dollars and get rid of them in a manner that gives them something that is going to retain its value. If I had the choice of stockpiling paper dollars which are falling in value against supplies of uranium, copper, lead, zinc, molybdenum, etc., I know which one I would choose. So what if a T note pays a yield of 5.2% or higher – if the dollar drops 10% you still end up holding the short straw if you are a foreigner.
That’s how I see things and why I do not agree with the doomsday scenario that those who are pushing the unwinding yen carry trade are postulating. I do not for one moment dispute that a great deal of money has been involved in the yen carry trade and that large sums of it found its way into various markets including real estate. But investment funds have always found sources of money to borrow for investment purposes. It matters not what rate those guys can borrow money at – what matters to them is can they borrow for a particular rate and invest it in something that pays a higher rate of return than they borrowed for. That is what leverage is all about. Does anyone seriously think that all these hedge funds are simply going to go away because they can no longer borrow money from Japan?
One other thing - Gold did not fall $100/ounce because of fears of the yen carry trade unwinding. It fell because the Bank of England precipitated an attack on the price of copper to try to save the LME from collapsing due to the idiots who kept shorting copper in the middle of a roaring bull market. They had to do something to stop the price of copper from rising or risk watching their members default. They could not obtain surplus supplies of copper which with to flood the market BECAUSE THERE ISN’T ANY! So why not attack the gold price which can be done by mobilizing Central Bank gold supplies and using that extra supply to temporary knock the floor out from under the gold market. Then you sit back and watch the financial press and the same old top callers in gold make the case that the commodity boom was over sending the speculators who were wining the battle heading to the hills in a mass selling panic of commodities across the board. Voila - Mission Accomplished!
In spite of the selling barrage copper is still trading at $3.50 pound. How many people in 2001 would have said that it was possible for copper to run to $4.00 pound and then drop sharply in price and still be trading at ONLY $3.50? Not 1 out of a 100 I would venture to say.
In conclusion, the commodity boom is no where near over and the current talk about a rout in the commodity sector is nothing more than the usual chatter that always surfaces whenever a market is experiencing a correction in a long term bullish trend.
June 5, 2006
Dan Norcini
Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments
-- Posted Tuesday, 6 June 2006 | Digg This Article
