A hundred years from now, when my descendants decide find out what their ancestors were thinking while financial history was happening, I want them to read this post. This is a post for posterity.
I remember in college reading about the depression in 1929 and thinking... what the hell were those guys thinking? Here I am in 2007 and now that we're about to see the current world's financial system crumble, I can understand how events like the 1929 depression happen. In my opinion, it all comes down to psychology and a lack of systemic thinking in our population.
What's happening? Simple. You know about the subprime market collapse, right? But have you heard about the yen carry trade? Probably not. Here's the currency carry trade definition according to Investopedia:
A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates - which can often be substantial, depending on the amount of leverage the investor chooses to use.
Here's an example of a "yen carry trade": let's say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.
When you read the Wall St. Journal and the other financial publications they blame the current financial irregularities and inflation on the Chinese and yuan. What a crock of shit.
The carry trade is a near limitless cash machine for banks and hedge funds. They can borrow at near zero interest rates in Japan -0.5%- to relend anywhere in the world that offers higher yields, whether Argentine notes or US mortgage securities. Yen carry trade fingerprints are found on just about every financial instrument today - credit spreads, bond spreads, you name it. In my opinion, all bubbles need a source. In this case, the Bank of Japan has been one of the main sources.
So what's the problem? Well, remember the aforementioned explanation of currency carry trade and the risk behind it? Yeah? The rise in the value of the yen with respect to most other currencies is effectively increasing the interest rate to the point that this source of cheap liquidity is drying up. Basically, what's happening is that people can't afford to pay the high-interest rate mortgages they were suckered into, and the speculators can't get access to easy money to cover their losses. The yen is rising. Speculators, running like chickens with their heads cut off, caught with losses on the sub-prime market and in the hedge funds, are scrambling to cash in their bets made with borrowed yen, buying yen to pay back their yen loans. This is causing the yen to go higher and generating further losses to previous yen borrowers. Do you see a cycle here?
Countries are about to go bankrupt and a new financial system will have to emerge. Time will be the judge.
