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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

World Liquidity Crisis Emerging as the Yen Carry Trade Unravels

Economics / Yen Carry Trade Mar 14, 2007 - 11:48 AM GMT

By: Christopher_Laird


With the unraveling of the Yen carry trade, a sequence of events has been set in motion for a world liquidity crisis. Combining this with ongoing pressure from US sub prime deterioration will further harm confidence in US and consequently Asian stock markets.

As of this writing, Asian markets are again down 2 to 3%. I had written last week that confidence in financial markets were dealt a major blow in the first wave of Yen Carry unwinding a week or so ago in the article titled Damage Has Been Done.

This week, we are seeing the second phase of market declines, the US Dow down 230, and as I said Asian markets down 2 to 3% again. To say the least, market sentiment is getting crushed globally.

Now, combine this with still huge Yen carry overhang, and a seriously deteriorating US economy, and we will now see, and are seeing, the emergence of a world liquidity crisis.

I am going to discuss some of the components, there are many facets. But first, I want to say that, with market sentiment now so badly damaged, and the fundamental problems central banks will now have trying to re inflate financial markets – pushing on a string-

the central banks will ultimately fail re inflating financial markets. I do not believe they can either save market sentiment in 07, nor overcome consumer sentiment that is falling like a stone right after the stock crashes of the last weeks. In my judgment, we are possibly right at the cusp of a stock decline of the magnitude of the 1929 stock crash sometime this year.

Now, many people believe that markets will likely recover, that this present world stock decline is merely a correction. But, I view the market recoveries in the US and Asia last week as a dead cat bounce. I am fairly sure that we are going to see a great world stock crash that will make last years stock declines near this time of year look rather benign. The trouble is, this time, the US is now facing the necessity of lowering interest rates, and that will add further fuel to Yen carry unwinding. Many other factors also will just drain liquidity from financial markets, including housing and commercial real estate… and so on, there are many facets to this emerging liquidity crisis so lets get started….

Interest rates and Yen Carry unwinding

What started in China with stock collapses about two weeks ago, and now again, yesterday, was merely the spark to a great deal of fuel ready to burn off in world financial markets – the huge and highly leveraged Yen carry trade. This money is invested in practically every financial market, and even gold and commodities are infected with Yen carry speculation. Gold and commodities get hit twice from this scenario, as these have been sources of gain, and gold is a liquid asset that is used to cover margin and trading losses. Thus, after the Chinese and Japanese stock drops, and the strengthening of the Yen, gold is sold off two ways – unwinding speculation and also selling for liquidity.

In fact, the recent gold sell off can be seen as a harbinger of the emerging liquidity crisis in general. As interest rates in the US are likely to be cut soon, particularly in this stock disaster, great pressure is put on the Yen carry. The whole motivation for Yen carry is to profit for on the huge interest rate spread of the US – 5.25% vs the Yen -.5%. People borrow that and either pocket the interest rate differential, or, worse, speculate with ultra cheap borrowed yen. 

As long as the Yen does not strengthen, and the US interest rate differential is maintained, all those hundreds of billions of dollars worth of Yen stay in their respective markets. The trouble is, we now have both the Yen strengthening, and a relative certainty of a US interest rate cut. The Yen carry is very much now set up for a vicious cycle of unwindings:

First, stock/financial losses cause selling/liquidation. Yen carry is then paid off, further strengthening the Yen, creating further pressure to unwind more borrowed Yen – causing further selling in financial markets, an another round of stock drops follows, and we get a vicious cycle of market drops.

Then, the US cuts interest rates to combat these, and the Yen carry has further reason to unwind, and another vicious cycle is now in play to cause stock drops.

All of this financial unwinding causes great losses in every market the Yen carry inhabits. This causes currencies to strengthen, and losses of capital for both investors and brokers who have bet/borrowed on low Yen. Losses of capital by these means loss of market liquidity. It does not help that investment banks like Goldman have huge positions in sub prime mortgages, and this market is collapsing. That causes further loss of financial liquidity – basically a wave of stock and financial losses are sweeping the markets, leading to further selling.

Stock losses lead to more stock losses and liquidity drains

As of this point, we can say there is several trillion dollar value of losses in stock markets. This loss means there is less money, and then combine that with a change of sentiment to fearful. The drop in portfolio values is a net loss in money, and is highly deflationary. This is such a drain on banks and investors that, as this value literally vaporizes, bank and market liquidity dry up. The stage is set for a real panic sell off in all financial markets, except quality bonds.

US sub prime losses and liquidity drain

As more news of sub prime losses comes out, the market literally dries up. Banks and institutions hold all manner of positions on these, to include the huge mortgage derivative and securitization and credit insurance. Banks and others now find they cannot sell these positions, and have to take huge losses. Goldman Sachs is a prime example. It is said the major investment banks have about 15% of their capital in these. The end result is these investment banks and everyone else holding sub prime investment products are now getting hammered and no one wants to buy, so these markets continue their death spiral. Here is a quote from an article Jim Willie just put out showing just how scary this market is deteriorating:

CIGA Rusty Bayonet is quoted to say regarding the last week of February,“I know for a fact that there was not a single buyer of subprime mortgages last week. I have a buddy who trades them and said he could not find a bidder down to 93... Essentially the subprime industry ceased to exist last week.” This is the stuff of bank crises, from liquidity seizures, which to date have been minimized and fully denied. The next phase will center on negative amortization mortgages. Link

The guy Willie quoted is aptly named Rusty Bayonet.

The outfall of sub prime losses cannot be underestimated. These comprise about 20% of all mortgages, and is just a huge dead weight on financial markets in all kinds of ways. These include:

  • Huge losses to holders of all manner of investment products based on this collapsing sub prime market – Example – Goldman
  • Cutbacks in credit from banks/institutions to stem losses – this kind of thing is a direct cause of a classic liquidity crisis in economies.
  • Rising lending standards that make it more difficult for borrowers to buy new ‘anythings', or refinance, leading to a vicious cycle of further credit deterioration, and banking losses. Home foreclosures, for example, are at ever higher levels.
  • A general reduction in all types of credit – to financial markets that were recently built primarily on this type of liquidity.

Economy falling into recession and that causes further market pressure

The last thing markets need with all this liquidation pressure and collapsing liquidity is further reason for selling. That is coming now from an emerging recession in the US.

We keep hearing the US consumer is still alive and well, but that is rapidly changing. In fact, consumer sentiment on some indexes dropped 10% just after these recent stock crashes.

What is more important, people clearly do not understand how rapidly the US and western economy can spiral into a crisis level economic collapse. To refresh your memory, remember how many waves of layoffs there were after the Tech crash?, and when 911 happened, things just got worse. The US, the EU, Japan, and China all were fearing deflation. That memory has receded from memory, but I clearly remember how fast the layoffs piled up in the US, and how bad the US consumer pulled back, as well as how fast companies pulled back from capital investment.

Do you see the ingredients in the wind for a real depression this time?

Pushing on a string

But I keep hearing about how central banks only have to turn on liquidity spigots to full blast and everything will be ok. That is not correct, this time.

Before I address why, if you insist on staying in stocks and such believing markets will recover and this is merely a correction, like last year, then you are gambling that the central banks (the only remaining market bull left soon) can keep markets elevated or even rising. I don't think they can this time. What comes after is one hell of a scary world economic contraction.

I mean, think about it. One thing that has kept world consumers going is credit. A lot of this has/had to do with the Yen carry trade that Japan tried to engineer to both stimulate their economy (low consumer credit) and elevate their stock markets. Well, after their stock and real estate collapses in the early 90's, the Nikkei fell from about 45000 to where it is now, around 16000! That whole reflation effort ultimately failed, and left Japan with the worst indebtedness in the West! 

Japan constantly has battled deflation since, and is still flirting with it. Just wait till the Nikkei finally collapses way below 10000 this time!

Basically, what the BOJ found out is that, by offering money for virtually zero interest, they were trying to push on a string. Japanese consumer sentiment was very low, and they refused to borrow. When the US consumer falls into the ‘pushing on a string' category, the world will tremble economically. We are just seeing that begin, and the present world stock drops are both anticipating this and causing/initiating it. It all had to happen.


Commodities are going to get hit badly. These have been infected with speculation, and Yen carry is involved. They are and will be selling off in months to come as stocks drop. There is also the economic rationale for them to drop as economies slow and demand slackens. Obviously, gold and oil will feel this pressure. Gold will ultimately detach from downward commodity pressure, however. As in any market, as commodities unwind, there will be further pressure to unwind. Commodities will likely fall to their historic norms at the minimum.

Markets and economies can slow fast and drastically

Again, I have to emphasize that as this world liquidity crisis spreads, central banks will fall behind trying to stem it. Also, you will be amazed at how fast the economies slow, and how soon the big layoff notices start popping up. Soon, the economy will be in a vicious consumer led recession that could even lead to a world depression and deflation. I really don't believe the central banks will be able to stem things this time from a cycle of economic slowing leading to falling consumer confidence and consequent deflationary pressures in the US and Japan. Ultimately China will follow, and soon too, because China definitely is set up for a deflation for its own reasons (massive mal investment -10% of their businesses are making money, did you know that? Massive hidden banking losses, massive local speculation in stocks and real estate that are presently getting wiped out)

The only way central banks even have a hope of temporarily stemming a stock led decline into a depression, if things get bad enough, is through literally monetizing the entire world stock markets! Who knows, the US and Japanese plunge protection teams may try it….

They won't succeed.

The Prudent Squirrel Newsletter is my macro economic gold newsletter. Subscribers were alerted right at the beginning of these stock crashes of emerging liquidity problems in markets and general sell offs due to the Yen carry trade, two weeks ago Tuesday, in email alerts about 10:30 am PST. I also told subscribers that I felt there was a serious risk of another general market sell off in last Sunday's NL.

They were also alerted again yesterday of my concerns for a second wave of Asian selling at about 3:30 pm PST. Since the Asian markets have tanked about 2 to 3%.

The newsletter is 44 issues a year published on Sunday, and email alerts are sent to subscribers as needed during the week.

Stop by and have a look.

By Christopher Laird

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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