powered by GlobeinvestorGold.com
If you're like many Canadian investors you've gotten a call from a nervous investment advisor recently telling you about the merits of cash. If you haven't perhaps you need to talk.
That's right, cash. It may seem like a strange recommendation considering customer and client alike make little to no money in cash. Normally, when the industry gets nervous investment advisors push defensive fixed income investments like dividend stocks or bonds.
It's different this time because it happens to be the fixed income market that is making investors around the world nervous. Good investment advisors have a research department behind them and the number crunchers are seeing caution flags over the amount of low-interest borrowed money building up on global markets, and the threat of rising interest rates.
A number of things resulting from the liquidity glut are fuelling the concern including the sub prime mortgage situation in the United States. The housing industry has been booming over the past few years, thanks in part to the easy availability of low cost loans to borrowers with poor credit ratings. With the threat of rising interest rates and a softening economy fewer lenders are eager to risk their money. As a result over-leveraged lenders are having trouble keeping ahead of default rates.
However, it's not only a few first-time home buyers with easy access to thousands of dollars that is causing sleepless nights in world financial capitals. It's the big institutional investors with easy access to a few trillion dollars conducting what is called the carry trade.
The carry trade is a complicated investment strategy where certain currencies in countries with relatively low interest rates are borrowed in large amounts to buy currencies and securities from countries with relatively high interest rates. Large sums of money need to be borrowed for the investor to make money on the difference, or spread, between the two rates.
Over the past several months the key currency for the carry trade has been the Japanese Yen. In an effort to spur investment the Bank of Japan has devalued the Yen by setting its benchmark rate lower than any industrialized nation. In fact, at one point the Bank of Japan benchmark rate bottomed out at zero. Of course, that's just a benchmark but big institutional investors with collateral could borrow as much as they wished for a few basis points above zero.
To get an idea of how much money is being made on the carry trade compare the current Bank of Japan benchmark rate of 0.5 per cent with the New Zealand Central Bank rate of eight per cent and even the European Central Bank rate of four per cent. Rates are also relatively high in Iceland, Britain, Australia and Brazil.
Global financial institutions are finding sweet deals by investing more and more borrowed Yen in even higher yielding bonds in those higher interest rate countries. The higher the yield, the higher the risk of default - and when you're looking at that much liquidity sloshing around that's where the nail-biting comes in.
Think of all the leveraged borrowing in the carry trade as a clock being wound tighter and tighter. Each part is stressed to the maximum and it would only take a slight shock on a weak part to unwind the entire clock. When global equity markets sold off in late July and early August nervous carry traders began unwinding their positions fearing the U.S. dollar would further weaken from the sub-prime situation and the Yen would gain strength against the greenback. As a result that comfortable spread the carry traders were enjoying narrowed.
Research firms UBS and Deutsche Bank have been forecasting a stronger Yen. If that happens the Bank of Japan would most likely raise rates to keep it low, which would tighten the money supply and starve the carry trade. Many question the ability of any central bank to control that unwinding and fear it could result in a global equity market freefall.
HSBC Securities market strategist Stewart Hall says he expects the tightening of liquidity and the easing of market risk to be orderly. “The unwind is driven by a function of an exit out of some of the high yield trades” he says. “You have a lot of concern over the repricing of liquidity in general”.
However, there's no denying the market jitters resulting from the high level of borrowed money in the world and the possibility that global lenders could call the loan in from an over-leveraged world - and it's that propensity for panic that has so many investment advisors nervous.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.