Dear A-Letter Reader:
The infamous "carry trade" since 2002 is about to draw to a conclusion this spring as the Bank of Japan raises short-term interest rates for the first time since 1989. And with the end of one of the greatest speculative trades comes the strong likelihood of a hedge fund blowout this spring or summer.
The "carry trade" is hedge fund parlance for borrowing in a low yielding currency and investing in a high yielding currency; over the last four years, some investors have earned a fortune borrowing in yen and investing in emerging market bonds and stocks. That's been one of the hottest trades in the world since 2003 as emerging markets have soared over 200%. Emerging market bonds have surged over 20% per annum since 2000. At the same time, benchmark Japanese government bond yields have hovered near 1.5%, making cheap credit abundant for speculators. But now traders and investors fear the party will end as monetary officials finally cut-off cheap credit in the face of a rapidly expanding Japanese economy and rising inflation. Throughout the 1990s, Japan suffered from deflation, or falling prices.
Extended periods of cheap credit have historically been followed by massive systemic shocks or mini-panics.
Towards the end of the real estate cycle in 1989, the Federal Reserve aggressively raised interest rates, resulting in the worst post-war collapse for commercial and residential properties in 1990 and 1991. The government had to create the Resolution Trust Corporation (RTC) to bailout the bankrupt Savings & Loans in 1991.
Once again, rising rates siphoned liquidity in 1994. This time, bond markets were hammered, suffering their worst decline since 1927. Following an extraordinary period of cheap credit from 1991 to 1993, the majority of global fixed income markets tanked in 1994 while Orange County, California, almost went bankrupt because of reckless derivatives tied to the credit cycle.
The greatest panic since the 1987 stock market crash occurred in August and September 1998 when hedge fund Long Term Capital Management almost collapsed, driving the S&P 500 Index 17% lower in two months. The hedge fund's near demise almost destroyed the credit derivatives market - again a systemic even which occurred following interest rate hikes by the Federal Reserve in 1997.
As the era of cheap credit draws to a conclusion in Japan this year, global markets will probably suffer another major correction - now eight years, and counting.
Eric N. Roseman, Montreal, Canada
Investment Director of the Sovereign Society