re lowering interest rates
was good for stocks, just like the high leveraging of the Yen Carry stuff. More unwinding and look out below as sell programs are set in place.
Where Liquidity Begins
There are two reasons Japan's rate outlook is a huge story for global markets. One, yields in the biggest government debt market will head steadily higher for the first time in more than a decade. Two, it may mean the end of the so-called yen-carry trade.
``All liquidity starts in Japan, the world's largest creditor country,'' said Jesper Koll, chief economist for Japan at Merrill Lynch & Co. ``When rates go up here, rates go up everywhere.''
What makes the carry trade so worrisome is that nobody really knows how big it is. For example, the BOJ has no credible intelligence on how many hedge funds, investors and companies have borrowed cheaply in ultra-low-interest-rate yen and re-invested the funds in higher-yielding assets elsewhere.
Nor are the Bank for International Settlements, Federal Reserve Bank of New York or the International Monetary Fund likely to know how much leverage this most popular of trades has enabled banks to build up. Ditto for regulators overseeing the dealings of portfolio mangers around the globe.
Carry-Trade Craze
During the past decade, the yen-carry trade has become a staple for many punters. A popular form of the strategy exploits the gap between U.S. and Japanese yields. Anyone borrowing for next to nothing in yen and parking the funds in U.S. Treasuries received a twofold payoff: the 3-plus percentage-point yield difference and the dollar's rise versus the yen. The latter dynamic boosts profits by the time they're converted back to yen.
Yet as the BOJ raises rates and more investors buy into Japan's revival, the yen is sure to rise, much to the chagrin of carry-trade aficionados. Realization the trade is moving against investors may send shockwaves through global markets.
It would start slowly with speculators suddenly closing positions that are becoming more expensive: dumping Treasuries, gold, Shanghai real estate, shares in Google Inc. or whatever else they used yen borrowings to bet on. The chain reaction would accelerate once the mainstream media jumped on the story.
If all this sounds far-fetched, think back to late 1998, which offers an example of the damage a panic among carry-traders can do.
Remember 1998
In October of that year, Russia's debt default and the implosion of Long-Term Capital Management LP shoulder-checked global markets. The disorienting period culminated in the yen, which had been weakening for years, surging 20 percent in less than two months.
Suddenly, just about anyone who'd borrowed cheaply in yen rushed for the exits. It prompted frantic conference calls among officials in Washington, Tokyo and Frankfurt. Just how big was the yen-carry trade? How much leverage was involved? What could policy makers do, if anything, to regain control?
Since then, the wild days of 1998 have been largely forgotten. And as Japan slid back into recession and deflation, the yen-carry trade was back in favor. Trouble is, just as then, officials have little data to go on to understand the enormity of the risks all this poses.
Clearly, the global financial system is in better shape than it was in 1998. For the first time in a decade, economies in the U.S., Europe and Japan are growing in synch. There's the added benefit of strong growth in China and most of the rest of East Asia. India is also growing rapidly.
A boom in the number of hedge funds globally hasn't destabilized the international financial system as critics expected -- at least not yet. The world economy's resilience in the face of rising terrorist threats and record oil prices also provides some measure of comfort.
Even so, it's not clear investors are taking the risk of rising Japanese bond yields seriously enough. Once the process begins, world markets may be surprised by how quickly Japanese rates shoot higher, taking the yen -- and all those who borrowed in it -- along for the ride.
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