The World's Biggest Market - Volatility Ahead

By Barry Downs
Aug 10 2007 2:42PM

www.kitco.com



Stock market investors, until just recently, thought they were well on the road to an uninterrupted banner year for 2007. In nominal terms, the biggest followed index, the Dow Jones Industrials Average, closed at 14,000.41 on July 19th. But in a world where central banks have a policy of perpetual monetary inflation, nominal values don’t count and its real values which constitute the bottom line. In real terms, the Dow would need to rise to above 14,200 just to break even and to offset the cumulative inflation, which has occurred since the previous DOW high which occurred in 2000.

The mantra of stock market bulls has been expanding global corporate earnings. Bond market investors, in the past period of cheap money, developed an insatiable appetite for the world’s riskiest and illiquid debt instruments. US bond investor’s mantra has been the relatively low historic inflation levels reported by the government. But, while everyone knows government inflation numbers are skewed, the rush into high risk debt instruments has been unprecidented.

Total US dollar daily turnover of all US stocks and the US government bond market is running just under $400 billion, but as we pointed out earlier in the year in our report entitled, “The World’s Biggest Market,” (Kitco 2/2/07) the foreign currency exchange market (FX), is indeed the worlds biggest market and is the fastest growing of all markets in global US dollar terms. The FX market has an average daily turnover, in US dollar terms, of over $3 trillion, which is more than 20 times that of global equity markets.

US money managers, who control about $20 trillion in assets, continue to be the biggest US dollar diversifiers. Over the past four years those money managers have cumulatively diversified over $1.2 trillion into foreign currencies. Foreign currency traders make money when there is volatility in foreign exchange markets. They make a lot of money when volatility levels rise and it now appears that a major sea change is about to occur in an area known as the yen carry trade, and that change will usher in considerably higher levels of volatility in FX markets.

The re-pricing of credit risk, which got underway in late July, will likely be the event to curtail the phenomenon of the yen carry trade estimated at upwards of $1 trillion. The yen consequently will lose its appeal as a vehicle in which to borrow cheaply. Higher yielding currencies like the Aussi and New Zealand dollar, which have been the recipients of carry trade hot money, will then begin adjusting downward.

The carry trade phenomenon has involved borrowing yen at 0.50% and investing in places like Australia which pays 6.25%, New Zealand which pay 8.25%, or Iceland with rates of 13.5%. Popular with hedge funds, which operate on a highly leveraged basis, the carry trade not only invests in high yielding currencies, but gambles in a wide array of markets where they think money can be made.

As long as the yen doesn’t appreciate, the carry trade is all right, but the yen in times of re-pricing credit risk now appears prone to appreciation and that places increasing pressure on any investors holding leveraged yen short positions.

So far the yen’s appreciation has impacted on the New Zealand dollar, which is down about 5% since late July. The yen’s tendency to strengthen is becoming correlated with bouts of stock market weakness, and when the currency’s rise becomes steady, major adjustment will show up in the Aussi dollar, New Zealand dollar, and Icelantic krona. If the time has come in the highly leveraged world economy (the US being the Summa Cum Laude of leverage) and economies succumb to the approaching credit crunch, deflationary forces could overwhelm central bank intervention. In that scenario, commodity prices will fall and the commodity currencies like the Canadian and Austrian dollar will weaken and only add to high volatility levels in FX markets.

The unwinding of the yen carry trade is out there looming and may begin sooner rather than later. The bank of Japan is expected to raise interest rates to 0.75% in late August, which will eat into the differential in interest rates, the carry trade exploits, but the yen’s appreciation is the real key to the unwinding process.

The relatively low levels of currency volatility in the past period will end as the enormous debt pyramid amassed over many years begins to unravel in one shock after another. Rising volatility levels in FX markets are certain to occur as currency readjustments kick in and speculators flee those currencies representing countries with the biggest debt problems. Perhaps kicking off the volatility will be the unraveling of the carry trade hedge funds. Pension and profit sharing funds and investors seeking to protect capital will continue to seek the diversity and liquidity of the world’s biggest market, the FX market..

Massive excesses in the world’s credit market, inclusive of mortgage debt, weren’t created over night and the fallout is likely to continue for years, producing a period of rolling volatility in all markets. Rising fear levels will reduce the desirability of risk and a full blown credit crunch is the likely outcome.

Fund managers with a proven track record in the FX market will be highly sought after and are sure to capitalize on volatile market conditions the world will experience in the period ahead. There is a standout Nevada based currency fund which comes to mind, with a 27 year track record and which boasts a 40% annual compounded return. Fund managers of that stature will be hard to find.



Barry Downs
(775) 852-3875
e-mail: downsb@prodigy.net

Ronald Gilchrist
(406) 493-0612
e-mail: rgilchris6135@bresnan.net