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The Real Reason for the the Stock Market Falls - Cheap Money from the Bank of Japan

Stock-Markets / Analysis & Strategy Mar 03, 2007 - 11:58 AM GMT

By: Money_and_Markets

Stock-Markets

If you think stock markets were the only ones that went haywire this week, look again:

The dollar fell sharply, especially against the yen ... Treasury bonds soared, with the long bond gaining almost a point and a half on February 27 alone ... and gold prices swung all over the place.

In other words, volatility went off the charts in almost every market I track. A volatility gauge maintained by the Chicago Board Options Exchange, for example, exploded 63% in a single day, the biggest increase in U.S. market history.

What single force links all this action? What little (or big!) beast could possibly be behind so many seemingly disparate market moves? Here's my answer …


A Cheap-Money Monster From the Bank of Japan

Stocks, bonds, high-risk mortgages, and commercial real estate have all climbed, in varying degrees, thanks to a combination of things, including reckless central bank policies and a complete disregard for risk by many professional investors.

But one big stimulant behind the runs we've seen in many of the world's investments is simple — money. I'm talking about pure, unadulterated liquidity. It's been growing by leaps and bounds here in the U.S. as well as overseas.

Who's the biggest culprit when it comes to doling out cheap funds? Well, the Bank of Japan certainly belongs on any short-list. The BOJ has kept its short-term interest rates extremely low — near 0% — for a long period of time. And it's been flooding its domestic economy with liquidity.

Here's the important thing — all that excess liquidity didn't just encourage Japanese borrowing and spending. Instead, it gushed all over the rest of the world, unleashing a force called the yen carry trade.

Here's how it works ...

Say you're a trader at Goldman Sachs, and you want to make a big bet on U.S. bonds. You're looking for the cheapest source of money you can find. After all, the more money you can borrow ... and the lower the interest rate ... the greater your potential investment return.

So you sift through international money markets and find out that a Japanese bank that will loan you a couple hundred million dollars at 0.25%. (This is what Japanese rates have actually been for the last few months!)

You receive the money in Japanese yen, then convert the funds into dollars. That's because you want to buy U.S. bonds.

This strategy can really pay off! After all, short-term rates are 5.25% in the U.S. So, right off the bat you're earning a 5% return (5.25% - 0.25%). This is called “positive carry.”

If you throw in some leverage, you can double or even triple those returns!

If you decided to invest in another country with even higher interest rates (New Zealand's current rate is 7.25%), you can really make out like a bandit!

And if you buy something riskier than short-term bonds — say, a junk bond or a complex derivative — you can get an even higher yield (and possibly more capital appreciation, too).

Investors naturally asked themselves: Why not engage in a massive carry trade? Why not borrow for virtually nothing in Japan and leverage that money into all kinds of other assets? After all, it was like free money.

How the Yen Carry Trade Can Crack Apart

The yen carry trade sounds like an investor's dream come true, but there's just one problem: Unexpected currency moves.

In the example above, you were borrowing in yen and investing in dollars. As long as the exchange rate between those two currencies stays the same, you're fine. And if the dollar rises against the yen, you're even better off because you're making money from the currency move in addition to the difference in interest rates.

A Cheap-Money Monster From the Bank of Japan

But if the yen starts — gasp — rising against the dollar, things can get ugly fast. Remember, you're going to have to pay back your yen-denominated loans by selling assets that are priced in dollars. Since it'll now take more dollars to repay your yen loans, you're losing out. If you opted for massive leverage, you're totally screwed!

This is not all hypothetical. It's happened before, most notably during hedge fund Long Term Capital Management's (LTCM) meltdown in 1998. The yen surged 9% in a matter of weeks that summer, then skyrocketed another 12% in just 72 hours!

End result: All kinds of assets got crushed, investors lost billions, and the Federal Reserve had to step in to rescue LTCM to prevent a global financial implosion.

Things look eerily familiar this time around!

Several days ago, the Bank of Japan raised rates from 0.25% to 0.5%. That helped provoke a rally in the yen, as did some stronger-than-expected Gross Domestic Product data.

At the same time, the sub-prime mortgage meltdown here in the U.S. — which I've been warning you about — got much, much worse. Loan losses and delinquencies surged. The value of mortgage bonds tanked. That caused derivatives that are linked to the performance of high-risk loans to blow up.

Lots of carry trade money had made its way into these investments during the housing boom. So the losses made a bad problem even worse.

Result: The yen staged a massive rally against the U.S. dollar on Tuesday. Meanwhile, risk-free Treasuries soared and stocks tanked. That's the unwinding of the carry trade at work!

Don't Ignore An Event Like This! Here's what to Look for Next ...

The upshot of all this action is that it reminds investors of an important lesson — that risk does matter. I think it's going to make a lot of people reassess their positions in the interest rate markets, too.

Here are some of my thoughts on what to expect next, and how to prepare:

This raises the odds that the Federal Reserve will cut interest rates. That's what Alan Greenspan did to stabilize the markets during times of crisis, even though doing so tended to inflate asset bubbles elsewhere.

With “Gentle Ben” Bernanke at the helm, it's all the more likely the Fed will do something similar this time around, long-term consequences be darned.

At the same time, high-risk money will get scarcer. The Fed might cut rates, but that won't prevent losses from investments that have already been made in the past. High-risk loans will pile up.

Banks and other lenders will be more reluctant to take on new risks. Fewer high-risk mortgages will get written. The takeover frenzy we've seen, fueled by a rash of easy money lending, could cool. Commercial real estate and REIT shares — which have done very well in the past few years — could make a U-turn and head lower.

Flexibility will be key, now more than ever. Buy and hold investing just doesn't work in these markets. These days, you have to be willing to trade, manage positions, and keep abreast of all the swings.

Martin and I are doing our best to help subscribers do exactly that in Safe Money Report . Just before the meltdown, we tightened a bunch of stop losses on our recommended positions. Those orders helped protect open gains and reduced the risk of loss.

Make sure you've got a chunk of your money in “safe haven” investments. Short-term Treasuries or Treasury-only money funds might not sound sexy. But they sure come in handy at times like these. They'll pay some interest, and keep your money safe from the wild swings in other markets.

If you're going to hold stocks, look for those with a nice dividend cushion. Stocks that pay dividends tend to outperform the high flyers in times of crisis, and they pay you while you're waiting out the turbulence.

Bottom line: The yen carry trade is a big factor. And until it finishes unwinding, you can expect global markets to be very volatile, with more downside risk. So approach all investing with extra caution.

Until next time,

By Mike Larson

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.MoneyandMarkets.com


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