Global Agenda: Tipping point for carry trade

No one actually has any clear idea of why this week's global sell-off in equity markets started in China.

By PINCHAS LANDAU
March 1, 2007 21:42
3 minute read.
Global Agenda: Tipping point for carry trade

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The unusually long headline above merely combines those of the two previous columns. Whether by luck or inspiration, last week's discussion of the carry trade immediately preceded this week's major shake-out in global markets, which was largely based on a perceived threat to the carry trade. The story of this past week therefore may be that we have we reached, or even witnessed, a tipping point in the carry trade. May be or may not be. No one actually has any clear idea of why this week's global sell-off in equity markets started in China. For an excellent debunking of some of the drivel pumped out in large doses in every media channel known to 21st century technology, see Fortune's Clay Chandler, available via CNN (http://money.cnn.com/2007/02/28/magazines/fortune/chinaselloff.fortune/index.htm?postversion=2007022812). His basic thesis is unassailable: the Shanghai so-called stock exchange is indeed a "crazy, insular casino," so there is no obvious reason for a sharp drop there - whatever its proximate cause - to send the biggest and most developed markets, namely, Tokyo, London and New York, spiraling lower, in some cases for several successive days. However, Chandler is not looking at the wider picture. The reason that shock waves travel outwards from the Far East is because that's where the money is. As we noted last week, most of the world's biggest speculators, whether they sit in Shanghai, Dubai or mid-town Manhattan, use cheap Japanese yen to finance their activities. For two weeks prior to what some Asians are now presumptuously calling "Black Tuesday," the big buzz in the markets was whether "risk appetite" was under threat. The term "risk appetite" is the politically correct term for rampant speculation, in which assets are bid up in price without regard to what would normally be considered their underlying value. The threats to risk appetite are not China-specific. Indeed, the biggest ones are the developing disaster in sub-prime mortgage lending in the US and, in a very different context, the growing assessment that the Americans may actually attack Iran. The tightening of Chinese monetary policy, and even of Japanese monetary policy, are also on the agenda, but are not seen as serious problems in the near-term. The point, however, is that the markets were already very nervous. With any number of leading indices at record levels (like the Dow Jones Industrials) and/or passing round-number milestones (like Frankfurt, Shanghai and Tel Aviv) after months of almost non-stop advances, many smart-money types were seriously considering if and when to "take some money off the table." There is always a specific trigger for a development that has much deeper causes and, apparently, the news of a large drop in the Shanghai index served as the trigger on this occasion. Avalanches start with one small stone being dislodged, and the mechanism of panics is similar. Except that this panic was short and sharp - in avalanche terms, there was a lot of noise and many small stones were swept away. So far, however, no large boulders have come crashing down. It would be surprising if, over the course of March, we didn't hear of at least one or two huge blocks - hedge funds, probably - having crashed to pieces during this week. But even so, it doesn't look as if this is the earthquake that many fear will engulf the over-extended, euphoric global markets. If that proves to be the case, it will be thanks to the tremendous liquidity in the system, and hence thanks to the carry-trade, which is ultimately made possible by the Japanese government. Two scenarios are then possible. The worse one is that the speculators will conclude that it was a false alarm, that the global financial system is actually more "robust" than anyone had believed - and that therefore they can go back to business at the tables (sorry, in the markets) as before. The preferable possibility is that this was an early tremor which, coupled with continued poor economic data from the US (likely, but hardly certain), will lead to a second, more substantive and hence more damaging market slump in due course - perhaps in May/June. Arguments can be presented for and against both scenarios. Obviously, no one knows - but one fact stands out from this week's events. An exceptionally long period of low volatility in global equity markets has just ended. Higher volatility means higher risk, so that those with a low appetite for risk (ie non-speculators) should certainly return to their seats and fasten their belts, and might be well advised to read the emergency procedures card. landaup@netvision.net.il

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