Prepare for a Storm

This article appeared in Forbes magazine, April 16, 2007
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In late February Alan Greenspan warned of the possibility of a recession. The next day the markets took adive. Since then anxiety has set in and market volatility hasincreased. Even Panglossian brokerage houses have warnedthat if a recession occurs, house prices could tumble 10%this year and the stock market could decline by 30%.

We must, of course, add to this noise some nasty facts aboutsubprime lending, which constituted as much as 20% of U.S.mortgage lending in 2006. And that’s not all: Another 13% ofmortgage lending was to borrowers with only slightly bettercredit than subprime. There’s a tendency for these borrowers, andtheir lenders, to live in a delusional world in which an inability toservice the debt is papered over with refinancings and creativerepayment schedules.

With default rates on the rise, mortgage‐​lending standardsbeing tightened and $500 billion in adjustable‐​rate mortgages tobe reset in 2007, we can expect the return of a half‐​million housesto a bloated inventory of unsold homes in the next six months.The collateral damage from the housing market is already bakedin the cake: Expect a continued slump in residential constructionactivity and employment, lower house prices that will force moresubprime lenders to the wall and put strains on the most leveragedparts of the financial system and a slowdown in consumptionexpenditures.

These bits and pieces suggest that enough evidence isaround to justify preparing for a storm. Based on the recentcourse of events, one business‐​cycle scenario that merits considerationwas fully developed in the 1930s by Friedrich vonHayek, a Nobelist and leader of the Austrian school of economics.For Hayek and the Austrians, things go wrong whena central bank sets short‐​term interest rates too low and allowscredit to expand artificially. The result is an asset‐​price boom.Asset-price booms sow the seeds of their owndestruction: They end in slumps.

During the slumps the economy is vulnerable to what Austrians termed a “secondary deflation,” where banks callin loans and are stingy about extending credit. Households producetheir own version, liquidating riskier assets (like stockmutual funds) and moving into cash and government bonds. Inthe economy at large, investment and consumption suffer.

So much for the scenario and theory. Just how can aninvestor prepare for such a storm? In other words, are thereinvestments that will do well if the economy deteriorates?

Amid the credit‐​boom phase of the present business cycle,the Japanese yen has been weak across the board, and is 25%undervalued against the dollar. One reason for this is that theJapanese government engaged in massive intervention to pushdown the value of the yen in late 2003 and early 2004. Investorsthought that the government was committed to a weak yenpolicy. That, and the fact that interest rates in Japan are someof the lowest in the world, meant that investors thought theyhad a free lunch in the form of the carry trade — borrowing inlow‐​rate yen, investing the proceeds at higher rates in othercurrencies.

The yen carry tradehas become wildly popular,accounting for perhaps$1 trillion of yen‐​denominatedborrowings, tradersspeculate (no one knowsthe true figure). The carrytraders, of course, immediatelysell the borrowedyen to acquire high‐​yieldingassets of the othercurrencies. All this sellinghas kept the yen artificiallyweak.

But that could changevery rapidly. Yen carrytrades are risky and can reverse very quickly. Then, the yen violentlyappreciates. Just consider the most recent unwinding. On Feb. 26 theyen was trading at ¥120.50 per dollar. Then a stock market tumblein Shanghai precipitated a worldwide selloff of risky assets. Carrytraders undid their positions, buying yen and repaying their loans​.By Mar. 5 the yen had spiked up in value to ¥115.15 to the dollar.

In preparing for a coming storm investors should anticipatefurther unwinding of yen carry trades and a significant appreciationof the yen. One way to play this is to purchaseout‐​of‐​the‐​money call options on the yen traded on the ChicagoMercantile Exchange. I recommend a December call at a strikeprice of 90.

Anticipating an eventual reversal of Swiss franc carry trades, anda sharp appreciation of the Swissie, I recommended (Sept. 4, 2006)selling a Euro/​Swiss futures contract. At present the position is losing2%. Relax and continue to hold it.