Iceberg Ahead for Dollar Boat

From the June-July 2006 Trumpet Print Edition

On March 9, the Bank of Japan announced that it was ending its “easy money” policy, which has kept interest rates near zero for almost 10 years and kept much foreign investment flowing into the United States. Low Japanese interest rates allow an investment strategy known as the Japanese yen carry trade—where investors borrow Japanese yen at low interest rates, then invest it in higher-yielding currencies like the U.S. dollar or Icelandic krona.

This policy has had the side effect of buoying up the U.S. dollar and the currencies of other recipient countries. The termination of this strategy, therefore, could have serious ramifications for the U.S. dollar—if events unfold the same way as they did in Iceland, which has been a sizeable beneficiary of the carry trade.

According to the Wall Street Journal, foreign investor retreat, triggered by the downgrading of Icelandic debt by Fitch ratings agency, resulted in the rapid unwinding of the carry trade in Iceland and has left the nation “trying to stave off a financial meltdown” (April 10). So far this year, the Icelandic krona has fallen 12 percent against the U.S. dollar, despite increases in Iceland’s central bank’s lending rate (which is now 11.5 percent). Also, the Icelandic stock market has tumbled nearly 20 percent—including its biggest one-day loss in 13 years—over recent weeks.

Denmark’s Danske Bank warns that the Icelandic economy could shrink by 5 to 10 percent over the next couple of years and its currency could fall by 25 percent.

The krona’s meltdown set off a chain reaction that hit New Zealand, Poland, Hungary and Brazil.

Jim Willie, financial analyst and editor of the Hat Trick Letter, says, “The yen carry trade unwind is probably the biggest potential change factor in the financial world this year …. When it unwinds, the damage will be pervasive …” (Daily Reckoning, March 20).

The yen carry trade works as long as interest rates and the value of the yen remain stable compared to other currencies. If Japanese interest rates or the yen value rises, it destroys the profitability of the yen carry trade and results in investors unwinding their trades.

This could be very significant for the U.S. because, as analyst David Chapman says, all the major players—including “investment dealers, banks, insurance companies, hedge funds and mutual funds”—are involved in the trade. What’s worse, the banks, investment dealers and hedge funds have leveraged themselves by speculative borrowing (Bullion Management Services Inc., March 3).

“Investors have some good reasons to fear the Bank of Japan,” especially in a world where so many financial institutions, governments and consumers are “leveraged to the gills” (Economist, March 11).

Carry trades account for hundreds of billions of dollars globally. As they start to unwind, that will affect foreign exchange, interest rates and the derivatives markets, which turn over a total of some $2.4 trillion per day—an astronomical amount. If the unwinding process becomes disorderly, it could easily develop into a major crisis.

Many economists feel that for Americans, the end of the yen carry trade is no cause for worry because the U.S. is a special case—the largest economy in the world; the U.S. dollar is the world’s reserve currency; U.S. Treasury bills are considered the safest investment available.

But America has many of the same problems as Iceland, including record trade deficits, massive debts, heavy reliance on foreign nations to buy its securities, and lending booms that have fostered soaring property values. Add into that mix the fact that the euro is continually gaining status as a reserve currency alternative to the dollar, and the U.S. greenback could be in very serious trouble.

Whether the end of the yen carry trade will be the final factor that sinks America’s economic boat remains to be seen, but even putting the yen carry trade aside, the boat is sinking.

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