Investment Themes for 2007/08 Part 2. Dollar vs Yen

US Pennies

There are two major components of this theme, the first is what’s known as “the carry trade”. This essentially involved institutional investors being able to borrow Japanese currency at interest rates of zero. All they had to do in order to make a fast buck is to invest it in another asset – say for example US T-bills – which generate a 4 or 5 per cent return. When the lending terms are up the investor can liquidise their US investment, pay off the Yen loan, and pocket the difference. Although it’s not quite this simple – with currency risks and inflation effecting the returns, essentially it has been used to speculate in a whole variety of assets. The problem comes when the interest rate on the Yen is increased – rapidly diminishing returns as not only does interest have to be paid, but the currency also strengthens, meaning the foreign investment is worth less in Yen terms. Although this is a small driver of currency movements, I think it may act as a trigger that pushes outbound investments down to the point where other investors lose confidence. The outflow of Yen could quickly flip direction, with offshore invested money rapidly returning to Japan, putting further upward pressure on Japanese interest rates. This will probably happen quite quickly as profits are squeezed, and the Yen inflow trend self-potentiates.

Foreign Currency reserves of US dollars in both China and Japan are massive. As China states it’s going to find investments for all these assets, it’s time to sit up and take notice. When these countries decides to stop taking anymore USD as reserves, or slow their uptake, it’s time to worry. As the US has been operating on massive fiscal deficits, it actually needs this massive uptake of money to prevent a collapse in the price of the dollar. Without the capital inflows from China and Japan preventing the depreciation of all the d ollars being produced, the real rate of inflation will be uncovered. This inflationary pressure will only be increased by the build up of foreign currency coming back into the country.

The worst thing will be that this is likely to happen when the US will be needing to stimulate it’s economy most, with house prices plummeting, and the consumer spending less and less. This inflation will reduce the effectiveness of any interest rate drops the Fed makes, preventing cuts from stimulating the economy.

All this is going to result in a huge run on the dollar. To be on the right side of this, building up a position in either foreign currencies, gold, or my preferred option – spread bets on the movements in the currencies are advisable. I’m making spread bets that multiply any tun on the dollar and increase in the yen, with possibility to leverage the trade further as outlined in my previous post.

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