The Great Unwinding

I hope everyone loaded up on some gold during the recent buying opportunity mentioned two posts ago. Gold is now headed straight back up again as the dollar continues its freefall. The ongoing appreciation in the Chinese yuan often discussed in this blog also accelerated this week. But today I would like to highlight another great investment opportunity for the immediate future - the unwinding of the yen carry trade and how you can profit from it.

The yen rose against every single one of the world's 16 major traded currencies this week, primarily due to the unwinding of the yen carry trade. What is this "carry trade," and why is its unwinding such a big deal?

Following the collapse of Japanese stock market and real estate bubbles in the early-1990's, Japan's economy sank into a depression that lasted until 2004. The current economic recovery is still tentative, but slowly gaining steam as Japanese trade with China increases by leaps and bounds. During the depression, the Bank of Japan cut interest rates drastically in an attempt to stimulate the economy, and Japan's overnight bank rate of 0.5 percent is now far and away the lowest in the industrialized world. A middle class Japanese worker with a good credit rating can get a housing mortgage loan for 2.75%.

The carry trade developed as a result of the disparity between Japanese interest rates and those of foreign countries such as New Zealand, which awards 8% interest on their government bonds. Literally millions of Japanese housewives in search of greater returns on their savings have marched down to their neighborhood bank and moved their savings into foreign currency accounts denominated in New Zealand dollars, Australian dollars, Canadian dollars, Swiss Francs, and even US dollars, and paying much higher interest rates than a passbook saving account denominated in yen. Foreign hedge funds, investment banks, and even wealthy private investors have gotten into the game as well, borrowing literally billions of dollars at very low interest rates and then investing it overseas in much riskier investments.

This carry trade only works as long as the yen stays relatively stable or decreases in value in relation to other foreign currencies. Japanese housewives know that an increase in the value of the yen by just a few percentage points can wipe out their gains in interest very quickly, so they monitor the exchange rates between the yen and their chosen currency fairly closely. Since Japanese investors tend to move as a group, once the carry trade starts to unwind, that unwinding can accelerate pretty quickly.

The unwinding mechanism works like this: The level of risk begins to increase in the market due to a stock market drawdown somewhere in the world. Foreign currencies accordingly start to fluctuate in value more than usual. That fluctuation in currencies causes some carry trade investors to get nervous and unwind their positions. To do this, they sell their foreign stocks or bonds or withdraw money from their foreign currency denominated savings accounts. Then they transfer that money back to their Japanese bank account. This involves converting their foreign currency back to yen, which causes the demand for (and therefore the value of) the yen to increase, and the value of the currency they are selling to decrease an equal and opposite amount. This rise in the yen's value then causes more investors to unwind their carry trade positions, and a vicious cycle is underway.

How bad can it get? During the market turmoil caused by the Russian government defaulting on its sovereign debt in 1998, the yen soared in value by more than 20% in less than a month, as investors fled from riskier investments. The markets quickly adjusted to that crisis and were rising again smartly just a few months later. This time will be quite different. What is happening now is a massive credit crunch like the late-1980's Savings and Loan crisis, only much worse this time due to the huge numbers of adjustable-rate mortgages that will be resetting throughout the next year, and the literally trillions of dollars of credit derivatives that are based on those loans. The value of the dollar is also dropping like a stone as it slowly but surely loses its status as the world's reserve currency, as discussed in more detail in previous posts.

These two inter-related factors have foreign investors fleeing for the exits, which has precipitated the beginning of the next great carry trade unwind. The yen has gone from above 124 to below 108 so far this year, and is accelerating upward. For the reasons discussed above, this will continue on and off depending on short-term market conditions until the yen finally settles out at at least 80 yen to the dollar and quite possibly beyond that.

What's the best way to play this? All the normal choices discussed in previous posts on the yuan and gold are available. The simplest and safest way would be to convert dollars to yen at a bank, but the interest rates on your yen deposits would be very low, and of course there would be no interest at all if you held your yen in a safe deposit box or in a safe under your bed (don't laugh too quickly - one of the best-selling consumer items in Japan throughout the early-2000's was small household safes). As the number of bank failures in the US starts to increase soon, don't be surprised to see safes gain in popularity. As mentioned in a previous post, your best bet if you go the foreign currency savings account route is Everbank.

Moving along the risk spectrum, the next method is investing in FXY, a currency Exchange Traded Fund (ETF) that matches moves in the yen-dollar rate almost penny by penny. FXY has options available, but only for about nine months into the future. If you choose to buy the options to gain leverage, buy the farthest out month (currently June 2008), and every three months sell those options and buy the new ones three months farther out (this is called "rolling over" or "rolling out" your options). A friend of mine who uses this method bought 23 March 2008 options contracts three months ago and just rolled them over to June 2008. He had a nice profit of $9,600 when he sold the March options. These are the best methods for people who only have a stock brokerage account and don't have futures trading ability yet. See previous posts for more details about ETF's and options on ETF's.

For real leverage, you can use futures contracts and options on those futures contracts. As you know from previous posts, I prefer the options on the futures contracts to the futures contracts themselves, since there is no question the yen will be higher against the dollar at this time next year, but there will likely be radical swings up and down between now and then. Using options instead of the actual futures contracts will keep you from getting stopped out or worse, getting margin calls, during those swings. I'm using the March 2008 9200 strike price options right now, although I don't recommend them for someone buying now as they have moved into the money recently, and out of the money options appreciate faster. Accordingly, I'm going to be rolling them into the June 2008 9500 strike price options soon.

To give you an idea of the effects of leverage, I bought those March options on October 19, 2007, and they are now up 215% each while the yen rate itself is only up about 6% since then. In previous posts I recommended Xpresstrade as the best online broker for do it yourself futures and futures options investing. As an update, at the end of this month, they will complete their merger with optionsXpress and cease to exist. At that point, I recommend switching to optionsXpress as a great one stop shop for all your investment needs. You will be able to trade stocks, bonds, mutual funds, stock options, futures, and futures options all in the same account in a user-friendly interface. I'm not aware of any other broker, online or offline, that offers that trading convenience at anywhere near optionsXpress' commission rates.

Just to round out the total picture, World Currency Options are also traded on the Philadelphia Stock Exchange. These were the original options on currencies, and were once the only way for the small investor to gain leverage on their currency investments. With the introduction of options on futures contracts, currency ETFs, and options on these ETF's, their days are probably numbered, but you can still use them as a way to gain leverage directly on the movements of an underlying currency.