Tuesday, December 25, 2007

More on the carry trade

I'm going to go over the carry trade a little more today. Notice in the first chart that no sooner did the yen start to strengthen than the Nikkei entered a bear market. Massive monetary inflation has been holding up the Japanese market just like it has the US markets. Once the BOJ took away the punch bowl things started to go sour.

Now let's take a look at the second chart. You can see for the last couple of years the US and Japan have been busy devaluing their respective currencies. We can see that in July that changed. The BOJ stopped running the printing presses. The US on the other hand turned on the presses full blast.

I think there are two reasons why this happened. The first one is shown in the bottom chart. Oil, good ole energy, the life's blood of any economy. What happened in July? Well oil priced in Yen was back nearing all time highs. Japan has the same problem we do. Liquidity is leaking into the commodity markets.

Japan's recovery from a decade and a half recession has been very fragile. What they don't need is escalating energy costs to force the economy back into recession. That's exactly what's been happening though as long as they have been following the Fed model of printing troubles away. Which actually just creates more and bigger troubles.

Now for the second reason that made this change in monetary policy possible. Japan held their elections in July and the ruling party was defeated. They lost the majority vote in the lower house. Now what do politicians do when they first come to office and don't have to worry about getting re-elected for a couple of years? They try and fix some of the problems of course. That's why the year after elections is often a year when the markets struggle. AKA 2001!

So now the new ruling party in Japan has 3 years before the next election. It's pretty obvious they are more concerned right now with keeping inflation from crushing their economy than trying to help US politicians get elected next year. I would look for the Yen to continue to strengthen and the carry trade to continue to unwind for a while.