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An interesting analysis by Desmond Lachman of the American Enterprise Institute appeared recently, entitled “The Euro’s Day of Reckoning”.   He makes some worthy points in the article, one of which is the problem of where the dollar is going to get its support amidst the possibly burgeoning fiasco of our heated real-estate lending practices. 

The Euro, he postulates, is itself fractious, due to the disparity between northern and southern Europe; the Yen continues to be weakened by the carry trade (more below); and Asian currencies are unlikely to feel glowing about bailing out the dollar. Full article link here (via Jeff Nolan).

Of note is that Lachman briefly mentions the carry trade with regard to the Yen — fairly important aspect in today’s global currency markets. A carry trade is simply making money between a currency with a low interest rate against a currency with a higher interest rate. Japan is still lending out lots of dirt cheap money (.5 percent) while the US is lending money out at a relatively higher rate (5.25%).  It’s easy to see how you can make money in this case — borrow low in Japan, sell high elsewhere (taking into account differing currency rates, etc.). Without getting into the mechanics, it’s a practice that weakens the target currency (in this example, the Yen).  

One trader I spoke to recently on the subject speculates that hedge funds are borrowing off the cheap yen and collecting on the higher Euro, and then taking profits from the Euro/Yen spread and buying US stocks. If this is the case, an interest rate increase in the Yen would hurt this practice, and could affect the US equities markets (if he’s correct).  However, if Japan doesn’t raise rates, it will continue to effectively short its own currency, making it more difficult to act as a bulwark for a potentially declining dollar.

Will Japan raise rates?  Unknown, but the country is going into an election cycle, so possibly not.

In the middle of all of this is the observation that there’s certainly been no scarcity of money. Over the past decade, we’ve had a glut of money seeking a home, which has done the odd thing of creating asset bubbles — normally the creation of more money creates inflation.  We had the dot com bubble, the real estate bubble (all asset bubbles).  Where will the money go?  Where is the next asset bubble?  

At any rate, one has to wonder about the current global currency markets in relation to the dollar (weakening, not helped by an administration that continues to burn cash like a drunken sailor in port), the Euro (strengthening, but potentially weak underneath as Lachman posits) and the Yen (assured of continuing to be weak due to the carry trade). Will European banks start buying dollars to abate the trend?

And yet the US stock market continues to rise. 

And in the middle is the American homeowner, wondering just what the hell is going on.

Your comments are welcome.

Alex Eckelberry
(And an important disclaimer: I’m just a blogging software guy, not an expert on money.)