The Damage has been done to the Financial Markets as Volatility Soars and The Carry Trade Unwinds

By: Christopher_Laird

Up to last week, people were saying the Dow and other major markets were ever rising, the VIX was at super low levels, risk pricing was way too low in all markets.

The Dow appeared to climb ever higher, super bearish writers and economists were questioning themselves about the stock markets that never seemed to drop, but just kept climbing ever higher. There was talk about the ever greater liquidity continually pouring money into financial markets. That is was/is true.

But that was then – a couple of weeks ago. Now, market sentiment everywhere has been badly shaken. The VIX rose an incredible 60% last week. Previously, its historically low levels indicated there was virtually no investor fear in the markets. In a very real sense, the damage has now been done, and financial markets of all types are like a seriously wounded aircraft carrier, listing badly and on fire. It still floats, but just barely. Just about anything can now finish it off.

Up to now (even still), speculators could borrow and leverage to the hilt – the Yen carry trade made that what appeared to be a relatively riskless endeavor. The amount of leverage in financial markets is at historic highs, and people did worry about that. First one investor puts up some capital, then, funds leverage that among themselves multiplying that leverage several times. Then multiply in derivatives that have infected every financial vehicle. I have stated you can consider markets at 50 to 1 leverage at the price margins – anyway.

Then the Yen started strengthening. IN fact, I wrote my subscribers in the last newsletter that many conditions that led to the last '97 Asian financial meltdown now exist. Any significant rise in the Yen is now an ever threatening market killer.

Once there was trouble in the Chinese markets last Tuesday, the underlying conditions of the Yen carry trade were ripe to unwind viciously. In fact, several conditions were in place that were major causes of the Asian Crisis of '97. These are:

• First, several years of Yen weakening.

• Second, sudden Yen strengthening. 

• A great deal of accumulated Yen carry in financial markets.

Back then, the Yen strengthened about 20% in a very short time, and caused a wave of cycles of successive Yen carry liquidation that led the Yen then higher, and then more Yen carry liquidation and so on. This is a self reinforcing feedback loop, and why the Yen strengthened so much then. It was so vicious that it took a huge effort by the US Fed, and other central banks to stop that loop. In the meantime, Asian currencies and financial markets melted down, and had major escalating liquidity problems.

Now, we have seen the Yen strengthen 6% amidst this and last week's market carnage. I had emailed subscribers that I expected further carnage last Thursday in financial markets and gold, since the Dow and the Nikkei had not recovered meaningfully after the Tuesday drop last week. 

After the Dow fell another roughly 125 points Friday, and the Nikkei down another 235, then Monday the Nikkei fell another 575, and the Hang Seng 777. The other Asian markets suffered similar carnage. Then, the European markets tanked several percent. The Yen carry trade figured largely, and as successive waves of it were liquidated, the Yen strengthened more. Gold continued to be hammerd as it was sold for liquidity.

Then, the US stock market appeared to hold Monday, but down 66 points nonetheless. I had mentioned to subscribers that we would see a real test of markets, and likely the intervention of plunge protection teams of the US and Japan. Then, probably a hiatus this week sometime in the carnage.

Now, Asian markets have recovered – slightly – the Nikkei is up several hundred points, but considering the carnage of the last week or so, anything good looks like manna from heaven. I would not call the recovery of the Asian markets so far Tuesday very convincing. 

Goldman Sachs put out a great article today discussing the fact that there must be many ‘dead bodies' out there who got caught leveraged to the hilt in trades last week as the Yen strengthened considerably- both in FX and the Yen, and in financial markets involved with Yen carry. These dead bodies will float to the surface in a short time – these unfortunate brokerages, hedge funds and the like.

The trouble is, that any shock now, particularly soon, will be taken as a signal for a massive follow on sell off to the drops this last week or so.

The present state of the Dow and the Nikkei are very weak- sentiment wise. The non collapse Monday of the Dow – only losing 66 points was encouraging to markets, and probably provided a nice impetus to the stabilization of the collapsing Asian markets today.

However, I certainly cannot term a 200 point rise in the Nikkei, and a 66 point drop in the Dow as encouraging either at this point. It is more likely just a temporary reprieve. In fact, I surmise that others who wanted to flee the markets, but have not, will take advantage of any market stabilization, and try to get out soon. As I said, the damage has now been done to the markets.

The other problem is the Yen carry trade is still very much out there, like water flooding our Aircraft carrier. Sooner or later, the weight of that will again cause successive waves of market liquidations.

Ultimately, it may turn over. (read great world stock collapse).

That remains to be seen, but it certainly is the big question of the day as to whether the ship fire fighters can put out the blazes, and the pumps keep ahead of the inrushing water, (ever pressuring Yen carry still outside the hull trying to get in) on our wounded market ‘Aircraft Carrier'.

In the Asian crisis of '97, that was barely done. (a world wide financial and liquidity collapse happened anyway).

This time, I consider the risks far greater. The Yen carry since has grown to incredible levels. And leverage in every market has also grown to incredible levels, and then add on top of that the explosion of the derivatives business – formerly at only $20 trillion about 1990, that is now, in my estimation over a $quadrillion in value (1000 trillion).

In the coming weeks, just one of the major new risks will begin to show. As Goldman said, there are undoubtedly many dead bodies, huge financial entities who have lost their shirts in this latest stock and financial crash. These will become known, and who knows how the already quite panicky markets will react, as when Ameranth fell, and Refco and scared the hell of markets then. But this time, the damage has already been done to market sentiment, and new such revelations of illiquid and bankrupt funds and such will clearly shake markets to a great degree now.

And there are other worries such as some surprise financial negative, some US economic statistic coming in under par, like last week when we heard that durable goods orders plunged about 7% in January…. But who can cover all the likely candidates for another market scare?

Will another overseas market collapse first, and then all others follow, or some other shock, and then the vicious Yen carry feedback look come in again and eat up the markets? 

Frankly, I think so. So, even though markets have temporarily stabilized now, I feel just about any significant new negative economic revelation will lead to phase 2 of these vicious crashes, then phase 3 and so on, with periodic hiatus. In fact, I think we could say that the stock bull of the last years is decidedly fatally wounded, maybe not just quite dead.

A week ago, I had notified my subscribers that I suspected a general market collapse that could take gold down with it, it being sold to cover margins and what not. That alert was sent out at about 10:30 PST last Tuesday, well before the worst carnage appeared. The public article of that appeared several hours later, it taking time to get stuff posted to internet.

Look what happened since. One hell of a lot of scary crashing after, for a whole week.

The Prudent Squirrel Newsletter is my macro economic gold newsletter. I track many economic parameters and read about 10,000 gold related news articles to ferret out coming changes in the gold market. Subscribers also get periodic email alerts when I see changes coming in the gold market. They have told me they are really happy with that aspect of Prudent Squirrel. The newsletter is 44 issues a year, published Sundays.

Stop by and have a look.

By Christopher Laird
PrudentSquirrel.com

© 2007 Christopher Laird. All rights reserved.
Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary

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