As The Carry Trade Unwinds: Potential Effects Abroad

Includes: EWA, EWU, FXE, FXY
by: David Andrew Taylor

Let's say hypothetically that one day we wake up, and the carry unwinds in a big way.....

I've posted a few pieces about what effects would be felt in Japan. I feel that if the carry would push over that cliff, Japan would actually be doing quite well from this. All of a sudden, all of the liquidity that the BoJ has been pumping into the economy, that has promptly left the shores of Japan looking for better interest rates everywhere else in the world, would finally have the affects that have been targeted.

First, all of that money would end up back into the banks in Japan. Those banks would be having mass meetings trying to figure out ways to loan it out to everyone walking the streets. $1 trillion is a lot of money to all of a sudden show up. Deflation would be a thing of the past. Instead, there'd be a bad case of inflation. All that cash all available to purchase the same amount of goods would drive up prices. Also, businesses would be able to pump money into their own ventures. Japan would likely end up with a domestically led economy and a strong yen to accompany it. The rise of the Japanese proletariat would begin.

But what about the rest of the world? What about gold? What about oil? What about commodities?

The rest of the world would see a dry-up of liquidity. After all, all of that money that just arrived back in Japan had to come from somewhere. Right now, it's sitting in the U.S., U.K., Australian, European, and New Zealand economies. All of a sudden, there's a trillion or two dollars gone. The ability for Americans, and other countries, to buy these commodities has dwindled.

Businesses in America would slow down as the amount of funds available, in the aggregate, dried up. The effects would be similar to higher interest rates, without the Fed even budging.

The fix for this here at home, and in other countries, would be for Central Banks to lower rates in order to provide enough liquidity for the economy to continue expanding at a level that is at or near full capacity. Fortunately, the affects of lower interest rates here in the States would have only a small affect on inflation. But, what affects would be present is that the carry unwind would perpetuate further as the JPY pushes higher and the ability of Japanese investors, as well as hedge funds, to profit on the carry dwindles into oblivion. This pushes more and more funds out of the U.S., and the Fed has to lower rates more and more to compensate, which of course perpetuates the carry to unwind even more.

All the while, the equities markets are likely to take it on the chin as all of these Japanese investors bail out. Commodities are going to slowly grind lower. Is it possible that we'd see a slowdown in the increase in inflation? Absolutely. After all, the big surges we saw with inflation from excess liquidity from both the Fed and from Japanese investors pouring into our Treasury markets, is now seeing the effects of a puddle of water in the middle of Death Valley. It's dwindling faster than an 83 year old hookers sex life.

I'm playing a short equities market scenario as well as a short GBP and EUR, and the AUD and NZD. I'm also long JPY. So far, three of the scenarios are successful. the other three are sitting at about parity on my entry levels. My outlook is on a larger time scale. I'm thinking several months out. Once the unwind starts to really get going, it's going to be like a snowflake rolling more and more, collecting more and more momentum. Eventually, it turns into an avalanche, and the village sitting at the bottom of the valley is pretty much doomed.