Friday, March 9, 2007

The Carry Trade as Keyser Soze

"And like that he was gone. Underground. Nobody has ever seen him since. He becomes a myth, a spook story that criminals tell their kids at night. "Rat on your pop, and Keyser Soze will get you." And no-one ever really believes."

"Keaton always said, "I don't believe in God, but I'm afraid of him." Well I believe in God, and the only thing that scares me is Keyser Soze" - Verbal Kint in the Usual Suspects

One of my other favorite lines from the Usual Suspects was when Verbal Kint (Kevin Spacey) says that the "greatest trick the devil ever pulled" was convincing the world he didn't exist. Scientists, when they look at planets, never really see the distant ones, but they know they are there. How? They see distortions in the light coming from stars, a bend if you will, in the spectrum. Based on the distortion of the expected light, they can surmise that the planet is there.

And so you are asking yourself, what does this have to do with economics or real estate, or really anything? Well, like the light bending, showing the existence of a planet, just like the market bent showing the existence of the carry trade or maybe it was all just coincidence.

Timeline-

February 21st- The Bank of Japan raises interest rates 25 basis points to 0.5%
February 27th- Bottom falls out of DJIA 30, Nasdaq, S&P 500
March 2nd- Reuters states "Yen has best week in 14 months"

The carry trade is based on two bets, low Japanese interest rates, and a stable or falling yen. A rising yen, and higher rates destroy the motives behind the carry trade. The actions of the BOJ were obscured for a day or two by a falling yen. As the effect of the increase was beginning to be priced into the traders models, the trend reversed. A hiccup in the Chinese market, created an avalanche around the globe. Traders unwound positions in the US equity markets (sell sell sell) and bought Yen to pay off their loans in Japan. End result, equity markets down, the Yen up. Sure enough, exactly what we would predict happened, the yen strengthened, and equity markets were hit hard.

Fundamentals have now reasserted themselves, but beware the of the devil we can't see. As Verbal Kint, would say, "The greatest trick the devil ever pulled was convincing the world he didn't exist."

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