Imagine you are a large institution like a bank, brokerage firm, hedge fund, etc. You see this photo and realize that Japan only charges 0.05% interest rate on the money they lend out. The rest of the world offers bonds that pay far more in interest rate percentages. You borrow from the Bank of Japan, and buy bonds, or make other more lucrative investments (stocks, real estate, notes). You make the difference. Pretty lucrative, eh? It’s been going on for years, and is known as the “yen-carry trade” or simply “carry trade”. In fact, the profit can be a two-fer since the 3-plus percentage-point yield difference can be added to if the dollar rises against the yen. This dynamic boosts profits because another advantage is gained when dollars are converted back to yen. You’re paying back a yen debt with yen worth less.

The problem is that when the Japanese economy grows too fast, the Bank of Japan considers controlling the growth by making money less affordable. They raise their prime rate, and “pull liquidity” out of the market (take yen out of circulation). This gets those invested with yen-carry trade dollars extremely nervous and they start to liquidate their stocks, treasuries, gold, real estate holdings, and so forth, at the same time. World Markets drop heavily, simultaneously, because the carry trade money is everywhere.

This isn’t the first time that a financial position became so heavily leveraged, causing a breakdown in the mechanism to create a mass exodus that created far-reaching financial problems. Back in October 1998, Russia defaulted on their debts and caused the implosion of a brokerage firm called Long Term Capital Management LP. This meltdown was discussed in James J. Cramer’s (Mad Money) book, “Confessions of a Street Addict”. Interestingly enough, the debt problem related to Russia not only hurt companies holding the debt (like Long Term Cap) but those other brokerages and firms that were leveraged to Long Term Cap brokerage. In addition to the debt problem, matters were made worse when there was a surge in the yen’s strength, up 20% in less than two months, at the same time.

Those counting on the weak yen (similar to a low Japanese prime rate mechanism), were now unwinding their investments and markets went “south” in a big way by month’s end (October 1998).

Let’s bring the issue back to the current time. Did we know that the Bank of Japan’s increase in their prime rate or an increased yen strength would cause markets to drop as trades unwound? Of course we did. The street blamed the Feb. 26th “correction” on a drop in the Chinese Stock Market. It’s easier to blame the Chinese government than to take the blame themselves and disclose the unbelievable role the carry trade has on the current world economy.

How can we monitor and forecast the next time this mechanism and domino effect are about to take place? I suggest the following:

Google the following on a regular basis:
William Pesek Jr. (Bloomberg staff writer that nailed the last correction on Feb. 22nd)
Jesper Koll (Chief Economist for Japan at Merrill Lynch & Co.)
Bank of Japan Meeting Schedule (currently April 27th, May 16-17, June 14-15, July 11-12, Aug 22-23 and Sep 18-19)

Be aware of the Japanese Economy’s Growth Rate. If it heats up and goes up over 4%, as it did last quarter of 2006, the Bank of Japan will dampen inflation and slow growth by increasing the prime rate. Most countries like the U.S. and Japan prefer less than 3% growth/year.

Watch for the Publication of the Bank of Japan’s MPM Minutes. The vote tally and the comments made in this document seem to have more of an effect on the carry trade than the actual meeting decision made, concerning the prime rate, the month before. The minutes are slated for publication on May 22, June 20, July 18, Aug 28, and Sep 25)

Know the Bank of Japan’s nine member Policy Board:

Toshihiko Fukui (Governor), Toshiro Muto (Deputy Governor), Kazumasa Iwata (Deputy Governor), Miyako Suda, Atsushi Mizuno, Kiyohiko G. Nishimura, Tadao Noda, Seiji Nakamura, and Hidetoshi Kamezaki. The comments they make and the votes they cast can have dramatic effects on worldwide markets.

Listen for hints that the Japanese bond rates are increasing. This is often another precursor for a rate increase.

Understand that the Bank of Japan will not upset and election year in Japan, and will table any prime rate increases for after the July 2007 elections.