New US$ carry trade is about to replace the yen bet. Where will this credit fountain gush to?

For many years after the Japan economy shrivelled when their 1989 asset bubble burst, the government embarked on a low (near zero) interest rate policy to stimulate the domestic economy. In order to protect its export juggernaut (eg Toyota, Fuji, Mitsubishi, Sony) the Bank of Japan had to keep the yen exchange rate low to ensure export prices remained competitive abroad.

A new phenomenon started to take off - the yen carry trade. From the 1990s, savvy investors realised they could borrow at near zero interest rates from Japanese banks and invest in new business opportunities that could easily return double digits. With financial services innovation and the use of leverage, they could double, triple and even ten-fold up their original invested capital. It was like being given a crowbar to lift many times a normal weight.The Japanese housewife was a typical example borrowing Yen 600k (equivalent to about US$5k) at 0.25% from her bank and investing this immediately in a New Zealand dollar currency deposit account (within the same bank!) earning 4% per annum. With leverage, her bank was reasonably happy to grant this US$5k equivalent into an effective US$10-15 k margin account for her to control. Investing in the NZ$ meant 8% to 12% annual returns were therefore no problem. Now you know why LV and Tiffany stores worldwide were so favoured by the Japanese tourists abroad! Similarly, if you were a profitable non-Japanese heavyweight financial institution the leverage granted could have been unbelievable. This could be put to work in an ultra-safe US Treasury 30 year bond earning 6-7%. The major US investment banks could have notched up 30-35% a year safely without losing any sleep over the size of year-end bonuses. Some took this further to leverage up 20-30x on futures contracts. The yen carry trade was a virtually risk-free investment for many years.

Even though there have been swings in the yen exchange rate with other currencies over the last decade, it is probable these currency risks were manageable given the short timeframes for trading and short term investments (see graph with US$ rate).
Chart: Pacific Exchange Rate Service


Since mid-2007, the yen has started to strengthen...as the US$ started to relatively weaken against major world currencies over growing concerns in its American bubble economy. As a result, the yen carry trade has been unwinding rapidly (aim being to avoid getting killed by the crowbar which now works against you).

Move forward to today...the conditions are ripe in the US for a new carry trade. The interest rates are at a near zero 0.25% and the Federal reserve has stated they're likely to stay there for "an extended period of time". The US$ is weak due to massive trillion dollar government deficits and quantitative easing ie. printing money with no restrictions. So it is not likely to strengthen any time soon. Certain banks deemed "too big to fail" are awash with cash and this needs to find a new home. What will be the new assets being sought? If one can pinpoint these, their prices will likely explode to the moon as too much money chases so few goods.
- US treasury bonds are a source of lavatorial jokes now. Long dated bonds will lose value over time due to their humongous oversupply and future inflation could take hold quickly. Tim Geithner is unlikely to appear in front of Chinese students anytime soon to defend the value of the US$.
- Overseas govn't bonds. All European govn'ts are similarly plagued with massive debts as a proportion of their GDP so inflation risk is also abundant. Political risk in Middle-East oil nations remain high. Singapore and China sovereign bonds are not a big enough market yet.
- Competitive currency devaluations are likely in future as exporting nations strive to protect jobs. This will tend to dampen countries' relative interest rate advantages which are already at record lows, so borrowing in US$ to put in another currency deposit with a favourable interest rate deposit is not worthwhile
- That leaves distressed commercial real estate, commodities and precious metals. Paper assets will be out of vogue as tangibles come to represent what money has always been designed for ...a store of wealth. What would happen if a chunk of this idle US money was to stampede into gold and was met with competition from Indians famed for buying this stuff enmasse for their weddings and Chinese who want to buy everything stealthily?