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The Japanese economy continues to spring surprises.
The economy grew faster than expected in the last quarter of 2006, at an annualised rate of 4.8%, according to latest GDP data. Better yet, consumer spending also surprised to the upside, contributing half of the gain.
“With the GDP figure showing good balance between internal and external demand, I’d give it a perfect score,” fund manager Masayuki Kubota of Tokyo-based Daiwa SB Investments told Bloomberg.
This is great news for Japan – but it might not be so good for the rest of the world…
One effect of the strong GDP figure was a surge in the value of the yen. It rose the most against the euro in two weeks, and the most on the dollar in a month. But its main strength came against the Australian and New Zealand dollars. Why?
Well, it’s all to do with that carry trade business again. We’ve been writing about this for a while now (if you want a more detailed explanation, click here: How stoozing could bring down the global economy) but basically investors have been borrowing money in yen (because Japanese interest rates are low, it’s cheap to do so). They then invest them in a high interest rate currency (like the Australian or New Zealand dollars), and make a nice profit from the difference in interest rates.
Sounds like a great idea, doesn’t it? Only trouble is, it works fine as long as the currency you borrow in is falling or stable against the one you are investing in. As soon as the direction changes – perhaps, say, because of an unexpectedly strong piece of economic data from the country you borrowed from – you run the risk of suddenly owing a lot more than you originally borrowed as the exchange rate moves against you. That wipes out any gains you might have made originally by playing the interest rate gap.
But despite the risks, the carry trade is thought to be one of the main drivers of global liquidity at the moment. We don’t know just how big it is – you can’t know for sure the reasons behind people buying and selling currencies – but analysts who try to downplay its impact are ignoring some fairly hefty warning signs.
For example, as Gillian Tett and Peter Garnham write in the FT, “the amount of bonds denominated in New Zealand dollars by European and Asian issuers has almost quadrupled in the past couple of years to record highs. This NZ$55bn mountain of so-called ‘eurokiwi’ and ‘uridashi’ bonds towers over the country’s NZ$39bn gross domestic product – a pattern that is unusual in global markets.”
While this investor interest has kept the ’kiwi’ stable in recent years, despite a chunky current account deficit, a sudden turnaround would absolutely hammer the currency. “If investors turn bearish on carry trades, then the New Zealand dollar will clearly crack,” says Mansoor Mohi-Uddin, chief foreign exchange strategist at UBS.
So is the trade likely to turn around any time soon? Clearly, no one can say for sure. The Bank of Japan may or may not rise interest rates next week to 0.5% (the GDP data make it more likely, but there’s a lot of political pressure on the Bank to delay for longer). And even if it does, the differential between the 0.5% and the 7% or so New Zealand rate is still very chunky.
But the last time the trade was this popular was in 1997 and 1998, right before Russia’s financial crisis saw global risk aversion leap, and carry trades unwound, pushing the yen up 25% on the dollar, and helping to do for infamous hedge fund Long Term Capital Management in the process.
And traders are getting more worried. According to Bloomberg, “options volatility on the yen against the dollar advanced to a seven-month high.” What does that mean? Basically, the cost of insuring against the yen rising against the dollar has gone up. In other words, it’s getting more expensive for carry traders to cover their backs, which is also likely to discourage further carry trading.
But wouldn’t the unfolding of the carry trade hurt the Japanese? Well, maybe a bit – but certainly not as much as everyone else. A jump in the yen might hurt exporters, but it would make imports cheaper, which would also be good news for stocks that are more reliant on domestic demand.
And of course, the main reason for the Bank of Japan raising interest rates in the first place would be more solid signs of a domestic recovery – maybe even the surprisingly strong GDP figures we’ve just seen.
As David Turner says in the FT: “It is hard to escape the conclusion that, although the unwinding of the carry trade will have some effect within Japan, the greatest effect will be outside its borders, as investments fuelled by the trade unwind. If the Bank of Japan’s first duty is to the Japanese, perhaps it can afford to be a passive onlooker after all.”
So overall, the future still looks bright for Japan – and at a time when massive storm clouds are hanging over almost every other major world economy, that makes it a buy in our book.
And you can read more about an exciting signal that suggests Japan is heading for another massive year of gains in this week’s issue of Money Week – out tomorrow. If you’re not already a subscriber, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.
Turning to the stock markets
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In London, the FTSE 100 closed above the 6,400 mark for the first time in 6 years, adding 39 points to end yesterday at 6,421. Wolseley was the day’s biggest winner, climbing over 7% on speculation of a private equity bid. Mining stocks also performed well, with Vedanta and Xstrata standing out. For a full market report, see: London market close.
On the Continent, the Paris CAC-40 closed 13 points higher, at 5,695. In Frankfurt, the DAX-30 gained 65 points to end the day at 6,961, as DaimlerChrysler – along with peers Volkwagen and Porsche – rose as investors awaited a decision on its loss-making Chrysler division.
Across the Atlantic, the Dow Jones achieved a new record close of 12,741, having risen 87 points as the likes of Caterpillar Inc, Honeywell International and United Technologies Corp all performed well. The Nasdaq climbed 28 points to close at 2,488, whilst the S&P 500 ended the day at 1,455, an 11-point gain.
In Asia, the Nikkei approached a 7-year high on the back of strong economic data. The index gained 144 points to close at 17,897 today.
Crude oil was unchanged at $58.00 this morning, and Brent spot was also flat at $55.55.
Spot gold climbed above $670 in Asia trading, but had dropped back to $688.10 this morning. Silver had fallen to $14 today.
And in London this morning, Anglo-Dutch publishier Reed Elsevier announced that it is to sell its Harcourt Education unit in order to concentrate on legal, scientific and scientific digital publishing. According to analyst Lorna Tilbian, quoted on Bloomberg, Harcourt could be worth between £1.6bn and £2bn. Shares in Reed Elsevier had jumped by as much as 6.3% this morning.
And our two recommended articles for today…
Is ethanol a viable alternative to oil?
– Forget tortillas – reports in the US press suggest that up to half of next year’s corn crop could be used to produce ethanol. To find out why Byron W. King fears this alternative form of energy could create more problems than it solves, click here: Is ethanol a viable alternative to oil?
What a US recession means for you
– Before Christmas, economist James Ferguson gave us his latest update on the state of the US economy – and what developments across the Atlantic mean for the UK. For more on the biggest threats facing the US – plus why, when America sneezes, the UK invariably catches a cold – see: What a US recession means for you