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Stephanie Pomboy Presents: A Yen for Risk


Could this be the 'icing' on the leverage layer-cake?


Break out the paper hats and start gettin' jiggy with it cuz' (in case you hadn't noticed), the fourth quarter party is underway. In what has become a seasonal spectacle, investors are cutting themselves a big fat slice of risk from the global market cake and shoveling it in without the least regard for how piggish they look. Even in these early days, the roundup of market performance for the quarter has the sugar-stained fingerprints of risk-seeking investors smeared all over it.

Hard asset protection has been dutifully dispensed in favor of paper with commodities lagging behind their Emerging Market cousins, precious metals underperforming base metals and spec bets being slashed (see addenda). Indeed, according to the CFTC, gold longs have been cut in half and oil longs have been completely unwound. Meanwhile, on the paper front, the rapacious appetite for risk has found stocks outperforming bonds and high-yield bonds trouncing high-quality. In fact, since the quarter began, Junk yields have actually declined -30bp while Investment grade bond yields have risen +13bp!!

The last time investors went on a risk binge of this magnitude was back in April. That's right, the month right before May
. And we all remember what it felt like coming off that sugar-high!! Watching the current feeding frenzy, it's hard not to worry about a repeat of that unpleasant circumstance today. The question is whether the indigestion that will inevitably follow will arise as a reaction to the cake itself (the 'risk' assets being purchased) or the icing (the leverage).

In May, leverage was the culprit. Rumblings from the Bank of Japan that it was ready to end its Quantitative Easing campaign and, in time, move to tighten, were sufficient to shake specs from their carry-trade roosts. With their cheap yen financing now threatened, they rushed to unwind their various positions, sucking money from all corners of the globe.

After a brief but ferocious liquidation, these positions were rebuilt…and then some. In the months since, short positions in the Yen have pushed deeper and deeper into record territory. Glancing at the increased wagers in the last two weeks, depicted in the chart below, one can almost envision the drool welling up in the corner of investors' mouths in Pavlovian response to the 4th quarter alarm bell. After all, what better way to add a little oomph to your year-end performance than lever-up --- borrowing at 25bp in a currency that is all but guaranteed to remain weak??

If these trader commitments are any indication, the yen-carry trade is now more than twice as large as it was in May! Thus any modest shift in the fundamentals underlying the dollar/yen could cause a Liquidity Event that makes May's dyspepsia seem like a muffled burp. (Check out yen and the VIX).

Of course, with the Fed busy huffing and puffing about inflation, such a shift in dollar/yen dynamics is the last thing on investors' minds. But that's precisely the point. Everyone is lined-up on one side of this bet. And if the housing bubble's deflation has half the impact we suspect it will (on consumer spending…and financial institutions), the Fed will be shifting gears sooner and more aggressively than the markets presently expect. Tomorrow's Existing Home Sales report will be interesting in this regard. Should it fail to endorse the popular view that 'the worst is behind us'… this big trade might begin to unravel.

In the meantime, those looking for anecdotal signs of a 'peak' in the yen carry trade last week. No, I don't mean Russia's announcement that it would apportion more of its reserves to Yen (although that is important). I am referring to Iceland's first-ever Samurai (yen-denominated) bond issue.

Talk about the ultimate expression of the yen carry trade! Iceland, one of the world's highest-yielding currencies, is borrowing in yen to finance investment at home. It took a while, but apparently the guys at Iceland's largest bank, Kaupthing, finally figured out that there was substantial Krona to be saved by borrowing at 0.25% in Japan instead of 14% at home!!

Could this be the 'icing' on the leverage layer-cake? With Iceland elbowing its way in for a slice of the carry-trade cake, this speculative bash is starting to lose its elite feel. Pretty soon, the other party-goers will be nudging each other: Hey, who invited those guys??? And, as they put their forks down and grab their coats, the long-delayed liquidity exodus will begin.
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