Last week, Former Fed Chairman Greenspan declared that the ongoing credit crunch is "identical" to the crisis of 1998 — when Russia defaulted on its debt and the giant hedge fund Long-Term Capital Management came to the brink of collapse.
I disagree. It's actually a lot worse.
The primary source of today's crisis — the mortgage meltdown in the U.S. — is far larger than the source of the crisis in 1998.
The number of hedge funds and other institutions involved is hundreds of times greater.
Most important, in my view, the borrowing of low-interest Japanese yen to buy high-risk investments (the "yen carry trade") is many times larger.
And now, it seems U.S. Treasury Secretary Hank Paulson shares my view. Indeed, this week Paulson warned that:
We have a severe crisis of confidence in credit markets.
It is likely to last longer than previous financial shocks of the past two decades.
It could even last longer than the turmoil that followed the 1998 crisis or Latin American debt crisis of the 1980s!
Good. At least someone besides us realizes this isn't an isolated pain that a couple aspirin can alleviate. And fortunately, your portfolio doesn't have to just lie there suffering. There are plenty of profits to be made as long as you know where to look.
One of my favorite vehicles: Japan's currency, the yen. Let me explain why …
Dust Off Your "De Lore-Yen,"
We're Going Back in Time!
Let's step back in time to 1997-1998, focusing on the Asian Financial Crisis.
That's sparked one of the greatest and sharpest rises of any major currency in modern history — the yen was up 20% in just one month, and much more as the year progressed.
I showed you this chart in Money and Markets two weeks ago … and I don't want you to forget it.
Reason: I have a feeling we could see a move of similar (or even greater) proportions very soon.
What was the big force behind the yen's powerful surge back then?
It wasn't economic growth — the Japanese economy was still suffering from an on-again-off- again recession that began earlier in the decade.
And it certainly wasn't the attraction of high interest rates, in as much as the Bank of Japan had been pushing rates sharply lower, maintaining a zero-interest rate policy.
Rather, the yen surged during the Asian Financial Crisis because of a surging worldwide aversion to RISK!
Let me explain.
In the 1990s, Japan slashed its interest rates practically to zero. So investors in the U.S. and elsewhere got the brilliant idea that they could …
Borrow Japanese yen at lower interest rates …
Convert them into dollars or other currencies …
Invest in higher-yielding, higher-risk instruments, and …
Make a fortune!
That's the "yen carry trade" — using borrowed yen to finance your investments in dollars and other currencies. And back in 1998, close to $140 billion was involved in this transaction.
But as soon as the crisis hit, investors scrambled to reverse the transaction:
They started losing a fortune on their higher-risk investments in the U.S. and elsewhere.
They rushed to sell them …
They bought Japanese yen to pay back the money they had borrowed from Japan, and …
They drove the value of the Japanese yen through the roof!
That's why the yen surged 20% in just one month. That's the powerful force that created one of the greatest moves in currency of all time.
Back to the Present
Now, I expect the same thing to happen again this time around, and possibly on a much larger scale.
Not only is the credit crunch bigger and longer lasting, as Treasury Secretary Paulson himself said this week. But the amount of money involved in the yen carry trade — estimated at $1 trillion or more — is about seven times greater.
Plus, there's another side of the story no one seems to be telling:
Japanese Investors Themselves Are Getting Scared, So
Many Are Repatriating Their Money Invested Overseas
U.S. and other international investors aren't the only ones who have hopped on the carry-trade bandwagon. Domestic investors in Japan are also a big part of this phenomenon: They've been just as quick as anyone else to borrow yen and invest it outside the Japanese archipelago.
Few analysts have paid much attention to this side of the story, perhaps because Japanese investors have typically been slower to run from their overseas investments. But that could be changing very quickly.
A catalyst: Just this week, Japanese Prime Minister Shinzo Abe resigned after his Liberal Democratic party was defeated in elections for the Upper House.
That leaves Japanese investors wondering if their government will now have trouble supporting the economy. Enough of a shock to alter the risk-appetite among investors in Japan? You bet!
In fact, that trend may have already been under way well before Abe's resignation. According to data from Japan's Ministry of Finance, Japanese residents sold more foreign equities than they purchased — to the tune of 273.3 billion yen — this past July. Then, in August, sales of foreign bonds outpaced purchases by more than 690 billion yen.
Year to date, Japanese residents are also net sellers when it comes to transactions in international securities, quite a departure from the prior two years when the Japanese were largely net purchasers.
And remember: When the Japanese (or anyone else) are investing in foreign securities with yen, they have to sell their yen to convert into a foreign currency, driving its price down. So all their overseas investing in recent years contributed to yen weakness.
Conversely, now it's the opposite: When they unload their foreign investments, they have to buy yen to bring their money back home, driving the yen's value up. And all this money repatriation by the Japanese is another big factor that should contribute to yen strength.
There's a pattern emerging: As risk continues to find its way back into global financial markets, we could see the floodgates open and a tidal wave of investors all over the world rush to buy yen.
The net result: Don't be surprised to see a yen surge that rivals — or exceeds — its massive rise of 1998.
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