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‘”Bit by bit, from a bad seed a big but sickly tree is built with glue, nails, screws and scaffolding. Conventional economics assumes the financial system is a linear, continuous, rational machine and these false assumptions are built into the risk models used by many of the world’s banks. As a result, the odds of financial ruin in a free global market economy have been grossly underestimated. By using such methods there is no limit to how bad a bank’s losses can get. Its own bankruptcy is the least of the worries; it will default on its obligations to other banks – and so the losses will spread from one inter-linked financial house to another. Only forceful action by regulators to put a firewall round the sickest firms will stop the crisis spreading. But bad news tends to come in flocks and a bank that weathers one crisis may not survive a second or a third.”

“This uncannily precise description of the present crisis above was not written by an economist. While some economists had warned for years about global trade imbalances, escalating house prices, of excessive consumer borrowing, none of them remotely foresaw the truly unprecedented feature of the present crisis: the total breakdown of financial markets caused by the unforced blunders by investors and banks. Modern economists were inherently incapable of understanding such a problem because they assumed that investors were ‘rational’ and markets ‘efficient’.

“These assumptions led inevitably to disaster once they were blown apart. The author who came so close to understanding the true causes of the present crisis was not an economist but a mathematician.

“Benoît Mandelbrot, a towering figure of 20th-century science, who invented fractal geometry and pioneered the mathematical analysis of chaos and complex systems, wrote the above words six years ago in his book The Misbehaviour of Markets. Mandelbrot’s ideas found fruitful applications in the study of earthquakes, weather, galaxies and biological systems from the 1960s onward, but the field that originally inspired his ideas turns out, in this very readable book, to have been finance and economics. Yet 40 years of effort by Mandelbrot to interest economists in the new mathematical methods, which appear to work far better in modelling extreme movements in financial markets than the conventional methods based on statistically ‘normal’ distributions, have been either ridiculed or ignored.”

                                                            Anatole Kaletsky


FX Trading –Are We Getting Close?

TOKYO, Feb 20 (Reuters) – Japan needs to help ensure exchange rates are stable for its economy to recover, its new finance minister said, as slumping global demand batters exports and pushes the nation deeper into recession.

A rapid rise in the yen, which cuts into the value of overseas earnings when repatriated, has only rubbed salt into wounds for manufacturers such as Toyota Motor Corp (7203.T) and Sony Corp (6758.T), many of whom have fallen deep into the red and are restructuring as their main markets contract sharply.

Data this week showed Japan’s economy shrank at an annual rate of 12.7 percent in the last quarter — its fastest rate since the first oil crisis in 1974, and three times the fall in gross domestic product in the same quarter in the United States.

Are we getting close to a bottom in $-yen (top in yen -$)?  We think so!

USDJPY Weekly:

Qualitative evidence: Carry trade likely dead for years as the great unwind drags on, Japanese investor repatriation close to done, normalization of yield spreads among the major currencies, and Japan’s tumbling economic growth and rising credit risk. 

USDJPY vs. Nikkei Stock Index Daily: See a divergence in what was a very tight correlation between the Japanese yen and Nikkei stock index. 

Of course we never know with this correlation stuff.  Maybe it’s a Nikkei buying opportunity, or a USDJPY selling opportunity, should this correlation snap back into place.  But, a change in correlation would not be a surprise given the qualitative factors stacking up to suggest we may be getting close to the end in the yen trend.

It’s about estimated probabilities and risk reward.  This one is looking very interesting on both counts.

Take care and have a great weekend!