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[VIDEO EDITION] THE JAPAN CARRY-TRADE CATASTROPHE HAS ONLY STARTED

Charles Sizemore


Chief Investment Strategist, The Freeport Society


August 9, 2024

Hello, Fellow Navigator.

Welcome to our second installment of our Freeport Navigator Videos.

Today, we focus on why markets ended last week and started this week bleeding.

There are, of course, many reasons for the blood bath: 

 * Upsetting unemployment numbers…
 * The possibility that the Federal Reserve has kept rates too high for too
   long. 
 * And a dozen others.

I wrote about this on Monday and then shared The Freeport Action Plan on
Wednesday. 

But there was something far more sinister going on… something that is still in
play.

So I got the editor of The Lead-Lag Report and my good friend, Michael Gayed, on
the horn to talk about what happened… and why it can happen again.

Click the play button below to watch now.



During our discussion, we explained why the only perfect hedge is in an English
garden… and why that’s exactly the way we want it and the only mindset you
should have when investing.

Don’t miss this interesting and informative discussion.


TRANSCRIPT

Charles Sizemore: Hi, Charles Sizemore, Chief Investment Strategist of The
Freeport Society here for The Freeport Navigator Video Edition. Today I have a
very special guest, Mr. Michael Gayed, the editor of The Lead-Lag Report, and
all-around macro guru. 

Now, Michael, first off, thanks for coming.

Michael Gayed: You and I have known each other for a while, and I would refer to
you as my, I think, Irish brother from another mother? I mean, I’m Egyptian and
obviously I don’t have any Irish lineage.

Charles Sizemore: Welsh, Irish, it’s all the same thing, right?

Michael Gayed: Yeah, exactly. But no, I appreciate the invite. I’m a big fan of
yours. And you and I have been of the same mindset as far as just how weird and
frustrating this environment has been for a while.

Charles Sizemore: Exactly. Now, one of your specialties is what you call
intermarket analysis, and that is highly relevant right now. Now, what is
intermarket analysis? This is the interaction of markets, how they affect each
other, how action in one market can affect action in another market, and what
insights we can glean from that as investors. 

That is particularly relevant to us today, because you might’ve noticed things
got a little bit choppy earlier this week. 

Things got insane actually. 

We had volatility have the single biggest one-day spike actually in history from
low to high on the day, as the biggest one-day spike. And it all started on the
other side of the world. 

So why don’t we walk through that. 

For those who aren’t familiar with what a carry trade is, how it starts in
Japan, and how it affects the world that we operate in… why don’t we just start
from the beginning?

Michael Gayed: So I’m glad you mentioned the intermarket analysis framework. To
your point, trying to identify the relative movements of asset classes and
sectors, how they impact each other. 

Most people have what’s called home bias. They think in terms of their own
borders. And whatever happens to the market is because of the economy, because
of politics, because of earnings. 

In reality, markets are all interconnected. Asset classes are all
interconnected. And from that standpoint, money is interconnected, and money
moves very freely. 

So back in August of last year, I started observing what I thought was a big
disconnect between small cap stocks, which are much more sensitive to the
domestic consumer (more along the lines of home bias)… and credit spreads,
meaning the differential between the high quality debt and low quality debt.

Usually when credit spreads are tight, meaning the bond market’s not worried
about bankruptcies by some of these highly levered issuers, small cap companies
outperform and do well. 

Why? 

Because small cap companies have a lot of debt. These are companies trying to
grow. If you’re a small business owner, what are you doing? You’re probably
reinvesting every single dime you got and maxing out your credit card, because
you believe in your business and you want to grow it. 

So I looked at that, and I said to myself, “Okay, there’s a disconnect here from
the narrative of this being a bull market, with credit spreads saying it is, and
then small cap saying it’s not.” 

Now, in order for credit spreads to widen, you need something to shock
volatility into the system. And I started thinking to myself, “Okay, we’ve been
in such a weird environment post-COVID, that we had the shutdown, we have the
reopening, we have the stimulus, we have the insanity of the politics,” which we
can probably touch on as well. 

And then you have the fastest rate hike cycle in history. But that rate hike
cycle has been driven by pretty much every country except one. 

That one country is Japan, which just totally disregarded the global
inflationary pressure post-COVID. Whether it was from the supply chain
disruption side, the demand side, anything like that. Okay.

Charles Sizemore: Well, Japan has been trying to generate inflation for the
better part of 20 years. So when they finally got some, they weren’t going to
complain about it.

Michael Gayed: Correct. Now the issue there of course is that, it’s what kind of
inflation they got. I mean, if you’re talking about wage inflation, great.
That’s the good kind of inflation. It’s just like we saw in the States for a bit
of time here, people getting higher incomes because of the inflationary
pressure. It was wage demand driven. People didn’t want to work unless they got
paid more. 

The issue though with Japan’s inflationary pressure, remember this is the third
largest economy out there, an industrial powerhouse. The problem is that as a
country, Japan imports all of its oil, and oil is denominated in U.S. dollars. 

So, every other country raised rates, Japan didn’t. 

Now there’s a spread between the interest rates of all these other countries and
Japan’s nothing rates. 

So if you are an investor, a big institutional player, and you want to leverage,
you want to borrow money to deploy elsewhere, why in the world would you do-

Charles Sizemore: Let me interject one thing just for the non-macro experts out
there. All else equal, higher interest rates mean a stronger currency, lower
interest rates mean a lower currency. Now, it’s obviously not quite that simple,
there’s other variables. But at its core that is the general rule. The higher
the interest rate, the more a currency tends to appreciate.

Michael Gayed: Right. And why is that? Because money starts fleeing the zero
interest rate economy, and puts it into something else you can earn money on.
Which is effectively what the carry trade is. It’s the idea that you borrow from
Japan, if you’re outside of Japan, you’re a U.S. investor, you’re a European
investor. You borrow in Japan, it’s basically free. You’re not paying any real
interest expense on it. Then it inherently means you’re shorting the yen because
you’re borrowing in yen, and you deploy it elsewhere. Why wouldn’t you?

You can put it in T-Bills. You can put it in the money market, you can put it in
Nvidia (NVDA), you can put it in AI stocks, the S&P. 

So you play that game, and what happens is you end up having a lot of leverage
that’s gone into other parts of the world, because it was free and cheap. 

Now, key to this is this idea that if you’re borrowing from Japan as a foreign
entity, you’re un-hedged to the currency. Meaning, if you’re borrowing money
from Japan, you’re converting your currency into yen first to do that. 

Charles Sizemore: And you want that exposure, because it’s your belief at that
time when you’re making that trade that the yen is going to continue to weaken.
So you’re happy if your yen-denominated debt just keeps frittering away relative
to the dollar, right?

Michael Gayed: Right. And so this is the key point that you’re hitting on, which
is that you’re borrowing a set yen amount. The currency weakens, which means
when you pay back that loan, you don’t have to pay back with as many currency
units as your stronger currency. So you love it as a borrower, you love a weak
yen. 

But then what happens, it must be true to the other side as well, right? 

You as the borrower must hate a yen that’s getting stronger because that fixed
liability now actually becomes more relative to your own currency.

So then again, you go back and you think through, “Okay, oil, yen. Yen keeps
weakening, oil priced in yen keeps rising.” You have all these people and
institutions that are borrowing in yen. 

So the Bank of Japan then at some point has to panic. Because they cannot
control the price of oil, but they can somewhat control the currency, the yen
conversion of oil. And that’s why we’ve seen them start to raise rates. 

Now the thing is, because there’s been so much leverage that has come out of
Japan through that carry trade, the yen appreciates. You as the borrower don’t
like that. You start getting nervous.

Well, what if the yen keeps going up and I got this liability? You know what?
Maybe I should actually reduce my exposure of how much I borrowed from Japan.
Maybe I should actually sell where I margined that capital into Nvidia,
treasuries, wherever else you’re going, just in case the currency side really
hurts me. 

Well, the thing is, if everybody does that at once, it snowballs in a tremendous
way.

Charles Sizemore: It’s the same dynamics as a short squeeze. Where you end up
with forced buying, you end up not buying because you want to, or not selling
because you want to, but because you have to.

Michael Gayed: That’s exactly right. And that’s why we saw this very sudden
seemingly overnight type of move. Now listen, and I want to get your take on
this. I mean, we have different ways of managing money. I’ve got a rules-based
approach. You’re doing asset allocation as well. There’s a short-term response
to it, and then there’s a long-term response to it. 

You’re going to be probably much more long-term than I’m going to be from a
tactical perspective, but maybe that’s an incorrect assumption. So as you
yourself saw all this happening, did it cause you to shift anything, change
anything to say, “You know what? Maybe this is going to be a big deal and we’ve
got to get ahead of it just in case”?

Charles Sizemore: Yes and no. So, in our case to the… Well, we follow our risk
management. So when we saw volatility just come off the charts, when we hit stop
losses, we got out. We don’t play that game of, “Oh, well, maybe it bounces
tomorrow.” Well, maybe it does, maybe it doesn’t. But you hit your stop, you
follow your rules, you move on. You can always re-enter another day. 

And so, we definitely pulled some risk back because of that. Now thankfully for
us, we did have a few volatility hedges in the portfolio anyway. We have a
permanent position in gold that had its own issues, of course, when everything
got volatile. But we do like to go into it with protection. Living in this Age
of Chaos, we’re ready for whatever the world throws at us.

Michael Gayed: Yeah. It goes back to the point you need insurance already there
before the fire happens, right? You’ve got to have something that can help you
on that. 

Now, I’ll tell you something that’s interesting. So on my Lead-Lag Report, I put
a poll out, generally curious as this is happening. And a lot of people have
been high-fiving me because I was on this a year ago. I mean, this is playing
out the way I thought it would, it just took longer to play out than I thought
it would. 

So the poll was, is this reverse carry trade dynamic more bullish for Trump, or
is it more bullish for Harris?

And it’s actually like 6,000 votes within a 24 hour period. And I think it was
like 78% said it’s more positive for Trump in terms of the elections. And this
goes back to the point about home bias, which is to say that, something that is
sparked outside of the U.S. can have all kinds of implications on who is the
president of the U.S.. 

And that’s why you have to have much more of a global view than just looking
within your own borders.

Charles Sizemore: No, that’s an interesting point. Because what would benefit
Harris between now and election day is calm stability, a sense that things are
stable. That would be the best possible scenario for her. The best possible
scenario for Trump would be continued chaos that makes people unsatisfied with
the status quo. 

So to the extent that this spate of volatility continues, that moves the needle
towards Trump. To the extent that it gets swept under the rug for the time
being, and we’ll see, that sort of moves the needle more towards Harris.

Michael Gayed: You know what’s interesting is, I’m sure as you’ve talked to
different investors, high net worth individuals, people that are watching us,
the narrative is “they” won’t let the market fall until after the election. I’ve
heard that so many times. And my response to that is that assumes that policy
makers are competent. That’s a stretch for me.

Charles Sizemore: I made the same point so many times. The biggest reason I’m
not a conspiracy theorist is that it implies that people know what they’re
doing. And if experience has taught us anything, they don’t. 

Furthermore, even if they did more or less know what they’re doing, and let’s be
clear, they don’t, wouldn’t they tell somebody, wouldn’t some guy tell his
girlfriend, tell his wife, tell his mistress? Wouldn’t the word kind of get out?
It’s not like you’re going to have this secret cabal keeping it all together,
who can also keep a secret? Because I don’t know about you, but I don’t know
that I’ve ever met a person who can actually keep a secret.

Michael Gayed: I think that’s spot on. And that’s why even when people say it
can’t happen in election year, it’s just amazing to me how people forget the
year 2000 was an election year. The year 2008 was an election year. The year
2020 was an election year. Stop. It’s just narratives. I mean, the point is we
don’t know. It could end up metastasizing into something that’s really ugly and
bad. 

And if it is the snowball, going back to my point about it starting with small
caps and junk debt, that credit spread dynamic, then there’s going to be a lot
more volatility to come. 

Now the question is what do you do about it? 

You mentioned you got to have insurance already, like gold. I always go back to,
you ideally want to have imperfect hedges. Meaning things that are not perfectly
inversely correlated to stocks, because you never know, things could start to
pick up.

Charles Sizemore: My professor from my undergrad derivatives class has a quote
that I had no idea what he was talking about when he told us, he told us to
write it down. So there I am as a 19-year-old undergrad, taking notes as quickly
as I can, having no idea what he’s talking about. It all made sense to me later
when I started my career. But he said, “The only perfect hedge is in an English
garden.” 

That’s actually completely accurate. There is no such thing as a perfect hedge.
And that’s why you always have to have a little bit of a margin of safety.

Michael Gayed: That’s exactly right. So I think bottom line, it’s going to be
interesting to see how it plays out. The one thing I’m confident in, and
actually I’m curious to hear your thoughts on this too, is that we’re probably
in a new cycle. 

And when I say new cycle, really what I’m referring to there is, there’s a new
set of leadership. I don’t even necessarily mean on the presidential side. I’m
just talking about in terms of where you’re going to get the most bang for the
buck from an investment perspective. 

And then to the extent that you also have new leadership on the election side,
even more so.

Charles Sizemore: Yeah, I would agree. Well, first off, I think we have shifted,
and this shift has been gradual over the last few years. But we shifted from a
period of lower vol, kind of more stability to higher vol, greater chaos. We’ve
referred to it as the Age of Chaos at The Freeport Society, and I think that’s a
very accurate description. 

And then beyond that, which assets lead, that is also part of that. Companies
that are a bit more able to roll with the punches, that are able to navigate
chaos better, asset classes that benefit from chaos. I would expect those to
hold their own, to probably outperform by a decent margin.

Michael Gayed: Yeah, I think that’s exactly right. And Age of Chaos is a very
appropriate way of describing. It’s probably a better way of describing what
Greenspan himself titled his book, which is The Age of Turbulence. It’s the same
concept.

Charles Sizemore: We’re not seeing the results of this today, but, the other
things yet to come, right? We do know that there is going to be a wrecking of
sorts in the debt market. We don’t know when that is. We don’t know when the
bond market, the bond vigilantes, will finally come out of retirement and shake
things up.

We saw a little bit of that when the Fed initially started its rate height cycle
two years ago. I think we’re really just at the beginning of it, because the
deficits have not gotten smaller. 

But the carrying cost of that debt has gotten a lot more expensive. And with two
trillion plus dollar deficits, really as far as the eye can see, this will hit a
tipping point at some point. When? Your guess is as good as mine. Our shorter
term models don’t really give us a lot of help on that. But I think that’s the
elephant in the room for any sort of macro discussion.

Michael Gayed: There is no such thing as fasting when it comes to government
debt, and I’ve been very public about it… the benefits of fasting, the
government would benefit from some fasting on its own. There’s another poll I
put out: who’s likely to add more debt to the system, Trump or Harris? And the
vast majority said Harris. Which is interesting to me because I mean, I can make
a case that both are going to probably eventually do the… 

In alternative reality, they probably have the same amount of new debt added to
the system, because Trump wants to lower taxes, and is still going to be
spending on defense. Harris is going to raise taxes and spend. No matter what
your political affiliation is, the one commonality is spend, spend, spend,
borrow, borrow, borrow. 

Charles Sizemor: What may actually determine which candidate would end up
blowing out the deficit more would be, which ones screwed up worse and pushed us
into recession and caused tax revenue to fall from that. That’s also, of course,
unknowable. We can’t really model that out. But suffice it to say there’s not
really a way out here.

Michael Gayed: There’s not. But I always go back to this: I don’t choose the
cards I’m dealt, I choose to play the game. And I think from an investor
practical perspective, you must have that mindset. Because otherwise you’re
going to be frozen as far as what to do.

Charles Sizemore: If I withheld from investing because of incompetent
governance, I would’ve been sitting in cash for the last 47 years… as long as
I’ve been alive. I would just never invest. So you operate in this environment,
you know that we have huge risk on the horizon, actually we have risk today, but
then we also have risk on the horizon. You know that, you operate within those
confines, and you navigate it the best you can. 

You do it by being tactical, by making shorter term moves when you need to. You
do it by having some hedges in place, even understanding that hedges are not
perfect. You have your hedges, you stay tactical, and you plow through.

Michael Gayed: Best anybody can do is exactly that. Yeah.

Charles Sizemore: Well, very good. That’ll wrap it up for today. Thanks for
joining me. This was great. Love to have you on again soon. To everybody
watching this, thanks for tuning in. 

This is going to wrap up this special video update at The Freeport Navigator. 

Until next time, to life, liberty, and the pursuit of wealth, this is Charles
Sizemore, signing off.


WRITTEN BY CHARLES SIZEMORE

August 9, 2024
Learn more

Charles Lewis Sizemore is a market veteran of 20-plus years. He holds an MSc
Finance and Accounting from the London School of Economics and a BBA in Finance
from Texas Christian University in Fort Worth. He is a keen market observer,
economist, investment analyst, and prolific writer, dedicated to helping people
achieve financial freedom through smart investing.


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