By Evaldo Albuquerque, editor, Exotic FX Alert
“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.”
…That’s how Paul Volker describes his tenure as the Fed Chief in the 1980’s. His job was to “slay the inflation dragon.”
That may sound strange – especially if you read how most Fed Chiefs have welcomed inflation and devalued the dollar over the last century in yesterday’s Sovereign Investor.
But Paul Volker is probably the only exception to that sad legacy.
Volker became a legend on Wall Street in the early 1980s when he hiked interest rates to curb strong U.S. inflation.
Until very recently, Volker was the head of Obama’s outside panel of economic advisers. But he just quit!
The guy who “slew the inflation dragon” was probably feeling like a complete misfit in an administration that’s clueless about inflation risks. I’m sure he didn’t want to be associated with a government that’s unleashing the dragon once again.
As Obama-style inflation rips through the markets, many investors will duck for the cover of hard assets. However, there is a better way.
You can earn as much as 400% from inflation risks with a single surprising play in the Forex market. I’ll introduce that play in just a second. First let’s take a look at how this coming inflation will shock the currency markets.
Fed Rumblings Will Send Bond Rates Higher in 2011
So far, pretty much all the Fed members agree interest rates must remain at just above 0%. This means most Fed-Heads aren’t ready to battle inflation at the expense of the economy. That’s why most investors are not focusing on inflation risks either.
However, that is about to change this year.
With economic momentum building, certain Federal Reserve bankers are now calling for higher rates. After all, unlike Bernanke, some Fed members actually care about rising inflation risks.
Once the discussions among Fed members start to pick up, investors will start speculating that the Fed will raise rates to fight inflation. Yields on U.S. bonds will have to rise to compensate investors for inflation risks.
Even though I don’t expect the Fed to hike rates this year, yields will start moving higher way before then.
That’s important because higher yields will cause incredible shocks in the Forex market. It will affect one currency in particular: the Japanese yen.
Japanese Yen: Ground Zero for the
Next Currency Shock
With its 0% interest rate, the Japanese yen has been the traditional 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. That’s because as interest-rate differentials between these two currencies will widen. When that happens, money will naturally flow out of the low-yielding yen and into the higher-yielding dollar.
With Japan trapped in an eternal deflation, rates won’t go up anytime soon. So the yen will once again become the favorite funding currency for carry trades. That’s when we will see the pair USD/JPY moving higher (the dollar will strengthen against the yen).
Check out the chart below. It’s very clear there’s 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.
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’ve seen 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 leverage that’s 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). Just keep in mind there will be a few pullbacks along the way, so make sure you have stop-losses in place.
As you can see, the Fed’s current monetary policy will shock the foreign exchange market this year. Shorting the yen will be a nice way to profit off these coming inflation shocks.
Editor, Exotic FX Alert