Mr. Practical on the Yen, Carry Trade, and Credit Expansion

Over the past several years there has been an excellent series of articles on Minyanville written by "Mr. Practical". Today's post, A Letter From Mr. Practical: No Return sums up very nicely, many of the things I have been talking about on this blog. Here is the latest missive from "Mr. Practical":

I have been thinking a lot lately about the state of economics and markets. From an intellectual point of view it is fascinating; from an emotional point of view it is scary.

Oh don�t worry about me. I am parked over here in Japan, long the yen that everyone else in the world is short. I am happy to lend these yen back out at basically zero to speculators since I believe that one day they will be forced to buy them back from me at much higher prices. This will occur when the Bank of Japan will finally be forced by the market to raise interest rates from their ridiculous �free� money levels. When will this be? Well, I think we saw the first strains of rebellion by Thailand a few months ago when it raised margin requirements. Speculation is rampant and they seem the only ones out here with any common sense. Just because they were �cajoled� by their trading partners to reverse course doesn�t mean those strains are still not there.

I am willing to forgo the 5% interest I can earn on other currencies for the expected value of doubling my �money� in a few years or sooner.

The Bank of Japan is a laughing stock. They are inflationists that would make any central banker proud; a country naively being used by others, especially the U.S., to dump liquidity into markets. Yes folks, there is rampant inflation in asset prices. Not only do central bankers of all stripes understate the cost of living, but asset prices like stocks and houses are now in hyper-inflationary territory. Being long assets that are in such a state is like taking a picture of an egg at the height of its toss: it looks fine unless one ponders the inevitable state of it being splattered on the sidewalk. The egg has been going up and up and up and it may go up further, but gravity is doing its work and it will not fail.

In normal times a good deal of market liquidity comes from income and thus savings. Economic production produces excess in certain societies and that excess is saved and invested. A little debt thrown in makes some of those investments happen a little sooner and with a little more return. But that debt is used prudently by those with the brains to have accumulated the necessary capital. Money is precious to them.

But these are not normal times. With GDP growing at 2-3% (I believe this to be overstated) and M3 (broad money) growing at an astounding 13% for the world�s largest economy, we have our first clue that things are not normal. Money is free to any who want to take the risk. When money supply grows you can by definition be sure that debt is growing commensurately. Debt is not used prudently because it is created easily for anyone and everyone out of thin air by central banks. Almost all of the current liquidity is coming from debt creation. This is the definition of inflation.

We now have an amount of debt in the system that would scare a hedge-hog. The only place left of moderate leverage is in some corporate balance sheets (as long as we ignore contingent liabilities like pension obligations and health care benefits). Corporations rapidly de-levered after 2001 (causing asset prices to deflate) due to perceived high risk and now they are rapidly levering again due to perceived low risk. Of course these two things, leverage and risk, are tied at the hip so once this latest and last form of levering is complete the forces of deflation, created themselves by massive inflation, will most likely advance.

Total global debt issuance jumped 14.1 percent from 2005 to a record $US 6.948 TRILLION in 2006. Leading the way once again was the U.S. with total debt issuance in 2006 increasing by 10.1 percent to $US 4.085 TRILLION. With the US economy at about 20% of the global GDP, it has issued debt almost three times its own relative global economic size. The U.S. now has total debt of 3.7 times GDP, a level never seen before.

At some point debt becomes deflationary because there is too much of it and the debt has been used to create even more overcapacity. We are starting to see in the U.S. signs, like sub-prime lending losses and higher home foreclosures, that income cannot support the amount of debt. Has anyone lately driven by a new commercial complex that is half empty while they are building a brand new one right next to it? As a result, new debt begins to have less and less effect on creating growth: in 1980 it took $1 of new debt to create $1 of GDP; in 2000 it took $4 and today it takes $7. We seem to be pushing on a string.

So when people say �there is so much money out there� it is the same thing as saying �there is so much debt out there�. Debt issuance is fueling speculation as this �money� is searching for return, any return, regardless of risk. All rates of return are being driven lower and lower in the search.

So why even look for return? As everyone else searches harder and harder for return and taking greater and greater risk to do it, perhaps the best thing to do is search for lower risk. It looks to me like Sam Zell agrees. This is very hard to do and perhaps that is why only some of the world�s greatest investors like Sam Zell have the patience to do it.

So what can you do about it?

This does not mean short stocks, for that takes timing and I care not to �speculate� on the timing of deflation. Central banks are adamant, but they are wrong, and eventually their methodology of creating new debt to fight the forces of old debt will not work. Instead of getting in the way, I suggest just getting out of the way. First, be prudent. Look carefully at your risks. Deflation hates stocks so be careful there. It also hates debt, so pay it back if you can.

Sincerely,
Mr. Practical

Notice the one thing Mr. Practical is doing that most others are not:
Mr. Practical has his eyes focused on the curves, potholes, and ice on the road ahead rather than looking in the rear view mirror.

A Warning From Trichet

The Financial Times is writing Prepare for asset repricing, warns Trichet.

Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos.

The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system, Mr Trichet said.

"We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

One might look at the statements from Trichet and dismiss them as some sort of contrary indicator. The context in which the statements were made and how they were perceived is at least as important as what he was saying.

Davos Elite Brushes Off Trichet

Rather than perceiving Trichet as a contrary indicator, I am looking at this headline instead: Davos Elite Brushes Off Policy Makers' Warnings of End to Boom.

Bankers, investors, and executives last week arrived at the Swiss resort of Davos giddy about record profits and bonuses. After five days of hectoring by policy makers that they are too complacent, they left just as happy.

"The mood has been totally upbeat," Sunil Mittal, the billionaire chairman of Bharti Airtel Ltd., India's largest mobile-phone operator, said of the 37th annual meeting of the World Economic Forum. "I've never seen a mood like this."

Warnings by central bankers such as Jean-Claude Trichet were batted away by dealmakers like Michael Klein, co-president of Citigroup Inc.'s investment banking unit, and David Rubenstein, managing director at the Carlyle Group Inc. buyout firm. They were confident in their ability to cope with the inevitable slowdown of the world's strongest economic growth in three decades.

"The consensus here in Davos is everybody's thinking it'll be another booming year," Morgan Stanley Chief Global Economist Stephen Roach said.

Emerging markets, led by China and India, are fueling the global expansion and corporate borrowing has never been easier. The amount of debt used to finance European buyouts reached a record high in the third quarter. The risk of owning European corporate bonds dropped to the lowest ever last week, according to credit-default swap traders.

Bond Risk

"The business community, the financial markets, the world economies are all actually in quite good shape," according to John Thain, chief executive officer of NYSE Group Inc.

`Plummeting' Costs

Griffin, who oversees a $12.8-billion hedge-fund group, was more concerned that government policy or too much regulation may send markets south.

"The price of liquidity has plummeted around the world," Griffin said. "It would be heartbreaking if you were to see regulatory or other changes in the marketplace push up the cost of liquidity again because it's been such a boon for the global economy, particularly for capital formation in South East Asia, Latin America and India."

Central bankers such as Axel Weber, head of Germany's Bundesbank, were blunt in their warnings. He said interest-rate increases in Japan will mop up the global liquidity that has helped fuel the financial-market boom of the past four years.

What is really the contrary call?

"The consensus here in Davos is everybody's thinking it'll be another booming year," Morgan Stanley Chief Global Economist Stephen Roach said.

Nearly everyone is giddy and openly dismissing the possibility of stock market plunges even though we have just seen enormous plunges in Mid-East stock markets. The International Herald Tribune is reporting Saudi prince plans big investment in country's sagging stock market.

The Saudi stock market "has reached reasonable levels," Alwaleed said. The Saudi prince said he would invest another 5 billion riyals, or $1.4 billion, in real estate projects in the kingdom.

The Tadawul, the second-worst-performing gauge after Venezuela among global indexes tracked by Bloomberg, dropped on Jan. 24 below 7,000 points for the first time since Oct. 21, 2004. The measure has lost two-thirds of its value since reaching a record in February 2006.

The Saudi stock market has lost two thirds of its value since February 2006. Of course everyone thinks it is impossible for the US to lose even as much as one third, barring some sort of huge interest rate hike or regulatory change.

"The price of liquidity has plummeted around the world," Griffin said. "It would be heartbreaking if you were to see regulatory or other changes in the marketplace push up the cost of liquidity again because it's been such a boon for the global economy, particularly for capital formation in South East Asia, Latin America and India."

Final Thoughts

Mr. Practical and I look at yield spreads, volatility, and options premiums and note that although they may get lower still they are a lot closer to the absolute bottom than any kind of top. On the other hand, willingness to speculate as measured by massive increases in derivatives is certainly nowhere close to a bottom. It remains to be seen whether or not things in derivative land can get even more extreme than now, but what is certain that much of this risk taking is going to be unwound, and most market participants will not like the result. The outcome is not really in doubt. The timeframe, as Mr. Practical points out, is still in play.

Someone posted on my board on the Fool that we could not have deflation with all this "money" floating around. My reply was that a massive expansion of money and credit is actually a prerequisite for an asset based deflationary bust. Every deflationary bust in history was preceded by an enormous asset bubble and/or credit expansion bubble that bust. Today we have both and it is harder and harder to keep that balloon filled. In 1980 it took $1 of new debt to create $1 of GDP; in 2000 it took $4 and today it takes $7. All of that extra credit is serving no productive means. It is pure speculation and it will be unwound.

Mr. Practical is correct about the carry trade as well. It will eventually be unwound. Therefore long term bullishness on the Yen seems to be justified. Short term, however, I am still sticking with my idea that there may be a huge breakdown in the Yen that causes some mammoth problem somewhere. If that happens I think we will see an enormous whipsaw that I want no part of. Thus from a personal practical standpoint I am sitting on the sidelines. Nonetheless I will have a few charts out shortly, to discuss the Yen in closer detail.

I sense the same thing in interest rates. Very few seem to think long term rates are headed lower even as commercials are starting to build a nice long position in the long bond and are slowly unwinding the short position in the 10-yr note. Commercials are now net long the 2-yr, 5-yr, and 30-yr treasury futures according to the latest commitment of traders report.

I am not sure what will pop this global credit bubble, but I suspect it will not be higher US interest rates or a rising Yen. More that likely it will be either pure exhaustion, something totally off everyone's radar, or simply the reverse of some scenario that everyone expects.

Thanks to Minyanville for sharing the wisdom of "Mr. Practical".

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/