Thursday, March 01, 2007

Cash and Carry Trade - Should we be worried?

My son is an inquisitive sort, and (according to his school reports) a maths guru for a twelve year old. So he has become very interested in the stock market troubles. After being peppered with questions I attempted to explain some of the potential problems we are facing. He was particularly interested in ‘carry trades’ that were being mentioned on CNN.

I explained that people with lots of money in investments, had been looking around for places where they could borrow money at a lower rate than the investments that they place this borrowed money into. Some time ago he negotiated a 1% per month interest rate from me on any money he saved, and promptly stopped spending anything, so he understand the concept. I said if he could borrow 1,000,000 Japanese Yen that would be worth about 10,400 Swiss Francs. The cost of borrowing the Yen would be about 1 odd percent, he could invest it with his pocket money savings and get 12% from me.

“So I would make about 1040 francs every year for doing nothing”. Was his enthusiastic reply. “Yes” was my reply”. “OK, let’s do that” was his inevitable response.

The problem with this is what if at the end of the year the money that you borrowed in Yen was due, you would have to pay it back in Yen. What if the 1,010,000 Yen you now owe cost you 13,000 Swiss when converted?

“I would have lost 1,352 Swiss Francs”. He says, not so enthusiastically, after a few minutes on the calculator.

I then explained why that could be. If all those rich people who had borrowed lots of yen to make investments, such as this, got worried and started to sell what they had bought with the money, then the price of the yen would start to rise. “If everyone was selling Playstation 2’s and buying Playstation 3’s on EBay you would get less for your Playstation 2 because there are more of them and pay more for the Playstation 3 because there are less of them” Was my feeble explanation of supply and demand in the money chain.

“So if you borrowed the money to buy Playstation 2’s you would not be too happy? You would be losing money on that as well as having to pay more back” he said.

“That's my boy!”

“So if people have bought shares in the stockmarket with borrowed money, they must be really worried” He said like a true market guru.

There you have it. A simplistic look at the carry trade, I agree, but if a twelve year old boy can see the potential problems why can’t everyone else. First of all, we are all not making complex carry trades and secondly a lot of the liquidity in the market is invested funds not necessarily required now. Long term plays like pension fund money and savings.

Also the economies of most countries around the world are still making progress so the markets should still be OK at least in the medium term..

The opportunities out there? Well yen investments look good. If you bought some Yen based Blue Chips and the Yen carry trades do unravel you would make money on the rising Yen, bonds will look to be more attractive and (you may be surprised to hear us say it) but selected smaller companies in your portfolio could be a good play, as they are less susceptible to macroeconomic forces, and lets face it, if people are selling blue chips they still will want to invest a portion in the market, its addictive. This influx of money may help the smaller companies tremendously.
Economies cannot continue to grow indefinitely in a straight line however, so we are due a correction at some stage and if this latest blip is not the start of it, then you can bet that it will be somewhere in our not so distant future. As the wider sentiment becomes edgy, anything can kick off a big correction. The Iranians having a punch up with the Americans, Central Banks controlling carry trades, rising interest rates, consumer spending reducing and the armegeddon scenario, a massively leveraged hedge fund going to the wall. We have seen these things before.

I am reminded of an old joke about a very bad actor who told his agent that he was getting rid of him because he had not found the actor any roles in years “Fine” said the agent, “But that is a bit like changing deckchairs on the Titanic”

When it comes, and it will, any investment could be a problem, at least for a while until the next bull run which, as sure as eggs is eggs, will follow whatever problems we face.

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