Your Dark Horse
I certainly thought that inflation was a dragon that was eating at our innards, or more than our innards, and if anybody was going to deal with this it was going to have to be the Federal Reserve. I saw the need to slay that dragon.
…Above, Paul Volker described his term as the Fed Chief in the 1980s. He said his job was to slay the inflation dragon.
That may seem odd – especially since we know most Fed Chiefs have welcomed inflation and have devalued the dollar over the last century.
But Paul Volker is most likely the only exemption to that sad heritage.
Volker became a legend on Wall Street early in the 1980s when he raised interest rates to rein in strong U.S. inflation.
Until recently, Volker was at the top of Obamas outside panel of economic advisers. But he just quit!
The man who slew the inflation dragon felt like a complete misfit in an administration thats oblivious when it comes to inflation risks. Im sure he did not want to be allied with a government thats unleashing the dragon once again.
As Obama-style inflation tears through the markets, many investors will run for the cover of hard assets. But, there is a much better alternative.
You can profit by as much as 400% from inflation risks with a solitary unexpected play in the Forex market. Ill explain that play in just a moment. First, lets review how this coming inflation will affect the currency markets.
Bond Rates Higher in 2011
Right now, most of the Fed members agree interest rates must remain at a fraction above 0%., which means that most Feds are not prepared to fight inflation at the expense of the economy. Thats why the majority of investors are not focusing on inflation risks either.
However, that is going to change this year.
With economic momentum building, a number of Federal Reserve bankers are now calling for higher rates. Unlike Bernanke, there are some Feds that actually care about rising inflation risks.
Once these discussions between Fed members start to accelerate, investors will begin speculating that the Fed will raise rates to fight inflation. Yields on U.S. bonds will have no choice but to rise to compensate investors for inflation risks.
Even though I dont expect the Fed will hike rates this year, yields will start moving higher long before then.
This is important, because higher yields will create incredible shocks in the Forex market. It will affect one currency in particular: the Japanese yen.
Ground Zero for the
Next Currency Shock
With its 0% interest rate, the Japanese yen has been the established funding currency for carry trades. In other words, traders have traditionally borrowed Japanese yen to invest in currencies that offer higher yields.
But when U.S. interest rates collapsed in recent years, the Japanese yen finally had some competition from the U.S. dollar. Traders started to use the dollar as a funding currency.
Once U.S. interest rates rise, the dollar will see a short-term spike in value against currencies with lower interest rates, such as the Japanese yen. Thats because as interest rates rise, differentials between these two currencies will widen. When that happens, sentiment will naturally flow away from the low-yielding yen and into the higher-yielding dollar.
With Japan trapped in an eternal deflation, rates wont go up anytime soon. So the yen will once again become the favorite funding currency for carry trades. Thats when we will see the pair USD/JPY moving higher (the dollar will strengthen against the yen).
Check out the chart below. Its very clear theres a strong inverse correlation between the yen and U.S. yields. When U.S. yields rise, the dollar gains in value against the Japanese yen. It happened in 2004, and it looks like it will happen again this year.
Higher Yields in the U.S. Will Force the
Dollar to Rise Against the Japanese Yen
The U.S. dollar is massively undervalued compared to the Japanese yen right now.
A small move in the 2-year Treasury yield, such as the one we saw in the beginning of 2010, would be enough to push the USD/JPY pair up by at least 8%. In the currency world, 8% is a HUGE move.
Using the leverages that are available in the Forex market, you can turn that 8% move into profits of 400% in the next few months. All you have to do is buy the USD/JPY (or essentially buy the dollar, short the Japanese yen). Realize there will be a few pullbacks along the way, so make certain you have correct stop-losses in place.
As you can see, the Feds current monetary policy will shock the foreign exchange market this year. Shorting the yen will be a great way to profit off these coming inflation shocks.
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