More Risk, Less Bonds

Investors consigned the Dubai World nonsense to the trash can on Tuesday but I’m not going to sit here and pontificate with an “I told you so” over the resulting rally for stocks. Even CNBC’s Jim Cramer called it right – and I’m not sure what that implies about my own intellect. Suffice it to say stocks rose to a 14-month high on Tuesday. The Wall Street Journal neatly summed up the domino effect stating that “investors sold dollars to buy stocks, commodities and other riskier assets.”

I reckon some of you are wondering how the heck any investor can sell the dollar and buy something. Surely you need dollars to buy companies shares in exchange? Yup, you’re quite right, but the more sophisticated amongst you will already know about the carry-trade. You see with stocks, you typically take some cash, buy shares in a company or mutual fund and then pay the settlement bill. But there are more savvy investors out there who understand how to better leverage their cash by selling out of the dollar for instance, in exchange for the Australian dollar or Brazilian real and using those proceeds to invest in local markets.

The carry-trade had been a pretty riskless trade and allowed investors who knew the minimum about relative yields to basically profit from bull markets anywhere around the world. Most popular during the bull market of yesteryear was to borrow a slug of Japanese yen at practically zero percent, sell it short in exchange for the Australian dollar, which paid anywhere between 6-8 percent and simply ride the crest of the wave. In addition the Aussie proceeds could then be used to buy local shares. If they rose by several percentage points investors would take profit and bank gains on the currency trade too. Easy money. Even Cramer could do it!

Nowadays, the Japanese have another kind of problem  - domestic prices are not only falling but according to recent Bank of Japan projections will keep falling for another 15 months. As Japanese investors seek protection against falling prices or deflation, they are bringing money home in droves to buy government bonds before the exchange rate further cuts the value of the foreign currency they are holding. By locking into fixed income now, they ensure some yield at a time when the economy is moving forward at a snail’s pace and bond prices are screeching higher. Investors want to lock into the security of government debt before yields dry up altogether. And the more the yen strengthens as more investors follow suit, the lower government bond yields will fall.

Indeed in an effort to stymie the rising yen on Tuesday the Bank of Japan announced it would lend $115 billion of 90-day cash to commercial banks in an effort to get them to lend more to customers to keep prices from falling further. The hazard here is that a stronger Japanese yen reduces the cost of imports and drags prices down. Can you see how the spiral is a never-ending problem?

And so the Dubai World crisis hastened the pressure on the yen as more investors chose it rather than the United States dollar when it came to seeking shelter from possible fallout. At the same time investors the world over jumped headlong into government debt for fear that equity markets would crash all over the place. The U.S. 10-year yield slipped from 3.36% pre-crisis to 3.17% over Thanksgiving when the crisis emerged.

On Tuesday, manufacturing data from around the world, including that in the U.S. continued to show expansion. And with stocks racking up gains, it should be no surprise to learn that bond yields began to creep higher. The 10-year yield closed at 3.28%.

A year end rally for stock markets, which we had expected prior to and during the Dubai World crisis, doesn’t jive with a rally in bonds. Just because the Japanese are seeing a bond rally doesn’t mean that bonds elsewhere can maintain their recent upswing. That’s just what we told readers to our Jurojin Weekly futures trading service on Tuesday morning before the market opened as we delivered an option strategy that is designed to bag gains from a reversal of fortunes for government debt. Stay tuned.

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The Supreme Council of the Secret Order of Jurojin

 Tyche Research

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