When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

Looking back on the first quarter, an impressive amount of the big news has hit the market. The political unrest across Northern Africa and the Middle East has entangled the US Military in its third shooting war, Japan endured the triple disaster of earthquakes, tsunami and partial nuclear meltdown, the European sovereign bailout took political prisoners in German elections and the largest bond fund manager announced that it had cashed out of US Treasuries. In the US, the housing market seems to have sprung some new leaks below the waterline.

What will the next few quarters bring?

One great place to start is ECRI’s Weekly leading index series which shows that the positive momentum is starting to taper off.This does not mean another recession is on the way, just that the current surge in the leading indicators (which correlate highly with the discussion and implementation of QE2) appears to have lost its head of steam.

Source: Economic Cycle Research Institute

What does this mean?

Investors are right to wonder how the markets for risk assets can be bogging down when there is still an estimated one-third of the QE2 campaign to be injected into the system? Part of the reason is that the likelihood of a QE3 has become more remote as even FED governors start to question the need to continue pumping liquidity into the system. Another part of the reason is due to the fact that much of the newly created money was used by big owners of long dated treasuries (Chinese government, PIMCO and others) to purchase other assets. The increase in base money did not have the desired multiplier effect because it was not used as fuel to create new credit in the commercial banking system. In the land of M2 money supply figures where most of us live, QE2 was a fizzle.

Last Spike?

Source: St. Louis Federal Reserve Bank

Pushing on a String?

Source: Shadowstats.com

Just over 4% growth in M2

Source: Shadowstats.com

The other side of the coin

For the big financial institutions who have access to cheap FED funding (or paying very little on demand deposits), the current state of affairs is still very attractive.But, as the situation remains very fluid, banks have shown a marked preference for Government paper (Treasuries, Agencies and Agency MBS) which can, in theory, be liquidated much more quickly than private mortgages and corporate loans.

But the banks are still burdened with a large backlog of toxic assets. Recent buoyant earnings reports and the cash flows behind them will not last if the whole yield curve gets shifted upwards by inflation or even just stronger economic performance.

Borrowing short and lending long works very well in flat or falling interest rate environments. Although we have seen lower interest rates recently, the FED has spent its political capital as quickly as it has built its balance sheet. Lower interest rates seem very unlikely in the medium term.

Sell in May and Go Away?

Does this mean we will reach another “Sell in May and Go Away” moment when QE2 runs its course? The numbers have been slipping from the 20’s to the teens in most of the Systems that we track, which suggests a cautious outlook.

As investments start to fall out of the top rankings and you look around for the new investment opportunities, it might be time to take a bit of money off the table and wait to see what opportunities arise after the next bit of bad news rattles the well priced equity markets.

The commodity sector suggests that not all of the optimism in the market is warranted. Most of the strength in the short term remains in Silver (SLV), which has just hit new multi-decade highs and traditionally serves as a store of value as well as an industrial metal. And despite exclusion from core CPI figures, the energy ETFs like UGA, USO, UHN and DBE are all running stronger than economic growth in the G8 economies might warrant (or appreciate).

Now that some of the dust has cleared from the international markets, it is a good time to assess the real impact of Japan’s triple disaster on your actual portfolio.

Why? Because it is sometimes important to look back and recognize that for most investors, the damage was in the 2%-4% range. It may seem cruel that financial markets can rebound so quickly after a massive earthquake, a tsunami and partial core meltdowns but, except for Japanese fund managers and the people who are suffering in the affected areas, the news cycle is about to leave the story behind.

The urge to “Do Something”

When we invest, we bring all the skills we have acquired in the non-investment world, especially those which have worked so well for us.

One of those skills is the ability to quickly react to stimulus. Our ability to survive in the world depends on quick reactions. Whether driving, walking, making decisions at work or social situations, our ability to react to our environment is critical to success. We actively seek to hone our reaction skills through education, training and experience. Some of our reactions are “hardwired” and so quick that when we put our hand on something red hot, our nervous system reacts even before sending the message to the brain. By the time the brain becomes aware of the incident, the hand has already jerked away from the hot surface.

What works well in the physical world does not always work as well when it comes to investing. For the short term professional trader, lightning fast reflexes may be important. But for the rest of us, letting the new information get all the way to the brain where it can be judged against the existing investment strategy is the way forward because trading, while cheap these days, is not cost free.

As the markets regain their pre-triple disaster pose, it is clear that “doing something” just for the sake of reacting to the news is not the best investment posture to strike. As the Nuclear plants are brought under control, we should see iodine and salt prices returning to normal, even in Mainland China.

What does Japan mean to the Global Economy?

Most observers reckon that Japan was either in or about to enter its next recession even before the triple disasters struck. That means the 4%-4.8% global growth rate that many economists are looking for this year did not rely heavily on a strong Japanese contribution.

What about Japan?

Although our initial reaction was that Japan’s financial prospects have not changed significantly as a result of the triple disaster, there has been one movement which bears further observation: the Yen.

The world’s Central Bankers are coordinating efforts to clamp down on the surge in the Yen that occurred in the aftermath of the quake (82.9 on March 10th to 76.25 on March 17th) as Japanese firms and individuals scrambled to bring money back onshore. Given Japan’s high level of indebtedness, one might expect the Yen to weaken as the scope of the disaster became clear. But, that would ignore the investment situation from the local perspective. Japanese individuals and institutions have spent the last two decades funneling money offshore to capture more promising returns than were available onshore. With a massive rebuilding program on the horizon, it would appear that investors are voting with their offshore accounts that there will be some attractive opportunities in the not too distant future. Japan has often only undertaken comprehensive restructuring as a result of Gaiatsu (outside pressure). Although usually a term reserved for foreign political pressure, the triple disaster comes at a time when Japan has largely exhausted its biggest source of finance (individuals saving through Japan Post Bank). That pile of savings is still very large but is more likely to be drawn down than grow given the aging of the population. Whether the rebuilding effort will be large enough to spur the economy out of its “Lost Decades” is something to watch for over the coming months. To succeed, a certain amount of intestinal fortitude on the political side will be required to allow for economic restructuring in addition to just reconstruction. The dramatic movement of the Yen suggests that the possibility exists.

So, how do we manage in such uncertain times?

There is no “System” that will predict an earthquake (large or small) or any other “Black Swan” event that might trip up the financial markets. Fortunately, the financial markets are more resilient than the 24/7 cable talking heads suggest. The problem with Black Swan events arises when one invests without a plan. Because, without a plan, all one is left with is panic and reaction. Unfortunately, with High Frequency Trading systems trading 50-70% of the daily volume in the US on timescales that are a tenth to a hundredth of the time it takes to blink, the reaction game is one in which an individual investor has no competitive edge.

The trick is to change the parameters of the game to play to your strengths. By taking a longer viewpoint, most of the market noise (intraday and intraweek volatility) cancels itself out. The remaining movement can be analyzed in terms of shifts in economic or financial fundamentals or investor perceptions of the same. This is an area where astute observations and an eye towards risk control can help one capture returns that will build wealth in the long term.

Whether you use the Fund King System or another investment discipline, it is important to keep a level head and make the important decisions (what to invest in, when to buy and when to sell) well before the markets inundate you with conflicting data. Not all of your trades will be winners but having solid parameters for judging winners and losers before the market starts reacting to the day’s events will leave you in a much better position to make astute investment decisions.

Or you can load up on iodine tablets…

What looks good this week?

Across the portfolios, we are seeing a deceleration in the small caps which performed in the first few months of the year. An interesting sector to watch is financials which may be poised for a big jump in top line growth if confidence in the US economic recovery grows. Banks in particular have been in balance sheet repair mode since the Global Financial Crisis started. If the focus switches to market share and revenue growth, we could see a big surge in financial shares in the US. XLF is currently ranking #2 in the US ETF Sectors Portfolio.

Silver (SLV) still looks solid both in the longer term portfolios and in the short term commodity portfolio. Energy looks good both in US terms (XLE) and Globally (IXC) and while events in Libya may influence prices in the short term, the longer term driver is increased demand from G8 economies that are still in the early stages of an economic recovery from the Global Financial Crisis.

The Seeking Alpha Portfolio

This week, we bid farewell to Taiwan (EWT) which has been nudged out of third place by the S&P 500 (SPY).

As noted in the past, the tech sector has shown signs of weakness that suggest either that economic growth for 2011 has been overestimated or that the tech sector is not going to benefit to the same degree as it has at similar stages in economic recoveries of the past. The fact that most of the tech innovation is actually taking place in software rather than hardware (apps vs. a new tablet; software as a service rather than installed applications) may be part of the puzzle as corporate budgets are spent on IT projects that deliver more efficiency rather than just building in new capacity. The system may be signaling that the pricing power lies with the corporate IT departments rather than the tech firms that will be supplying them.

Oil, Food and US Big Caps

With SPY nudging out EWT, we should be on the lookout for signs that confirm or contradict the idea that the US will grow at a solid 4% plus rate. Unemployment will continue to draw headlines as the Republican presidential candidates start to turn Political Action Committees into formal campaigns in the coming few months. However, it is important to keep two things in mind.
1) Unemployment is a lagging indicator of economic growth in the best of statistical times. And
2) US statistical methods tend to understate new employment in recoveries and overstate the situation in downturns.
So, with a double lag effect, investors should not put much weight on payroll releases. By the time they flash “green”, most of the recovery may be finished.

My buy order for EWJ was ignored on Tuesday morning. It wasn’t a large order. I was just putting it in to see if I could pick up the ETF on the cheap.

Unfortunately, I got a bit too clever on the limit (previous close less 10%) so I did not get filled. By 10am, I was pretty sure that I had missed the boat.

Why is that important?

Because the market meltdown in Japan and subsequent bounce are not being driven by rational calculations of the damage to the economy…it is just guesswork at this point. Nor is it a rational response to the nuclear power plant disaster. Our only comparable nuclear power accident scenarios happened decades ago.

It was the dramatic movement of money.

Smart Money Investors panicked and stabbed the sell button as soon as they saw their competitors doing the same. No one was waiting to see if mutual funds were going to be redeemed on the back of the shocking pictures and videos that blanketed the airwaves and bandwidth.

But, foreign investors only own about 25% of the Japanese equity market. There was only so much they could do. And once the selling pressure eased off…investors jumped in and bid the market up (both in Tokyo on Wednesday and EWJ not long after the opening bell on Tuesday).

The lesson in all this is that the weight of money can have dramatic effects on the value of assets. Japan’s “big picture” has not changed since last week. This week it is still the world’s #3 economy with an aging population, strong export sector, shocking level of government debt and extremely low interest rates. In the short term, it has sustained a mighty blow from Mother Nature but it has the institutions and experience to deal with the disaster. Fundamentally nothing much has changed. Emotionally, there have been several very big shifts.

What does the Fund King System have to say about it?

The System was not built for “Black Swan” events like this. What it can tell you is that Asia leading up to this event had some pretty crummy numbers behind it. Japan was the strongest of a weak bunch but the whole region is under a dark cloud of uncertainty over China’s short term economic outlook.

The first shocks have hit the market and there will undoubtedly be more aftershocks. One of the longer lasting aftershocks will be in the energy sector. As governments around the world (like Germany) take a close look at their nuclear power programs, the demand for oil is likely to rise. With the popular uprisings in Northern Africa and the Middle East threatening to disrupt the supply side, oil prices are likely to remain firm for the foreseeable future.