Yen carry

Nice article. Too bad the Bankok Post only keeps their articles online for one day! I had to dig pretty deep to find the article in a cached page. I would like to see the Fed do a study to determine to what extent low global rates (Primarily Yen, but also Euro) are responsible for keeping US Treasury rates unusually low. The market has developed convenient excuses to explain the negative yield curve, mainly that there is an implicit forecast of a recession and Fed rate cuts in the future, but the real reason could be that many investors actually find a 4.5% yield high relative to funding costs.

Here is the article:
The yen carry trade

Considering the global volatility these past few weeks, pundits have been looking to blame someone or some event and this time it appears to be the yen carry trade once again. Although the Chinese market fell 9% and was the catalyst that spurred a global equities sell-off, the yen carry trade has been receiving most of the blame.

What exactly is the yen carry trade and who uses this type of complex strategy? Interest rates have been at or around zero in Japan since the early 1990s and the concept of the ''carry trade'' has been around for ages. Carry trades are used by institutions and advanced hedge funds seeking relatively risk-free yield. It is a strategy in which an investor sells a currency with a low interest rate (i.e. Japanese yen yielding just 0.25%) and uses the proceeds to purchase another currency at a higher-yielding interest rate (i.e. US dollars at 5.25%).

Locking in the difference is the key and, if leveraged, the gains (or potential losses if the trade goes sour) are magnified. The previous example would give the investor 5% (5.25%-0.25%) as long as the dollar/yen exchange rate stays constant. Therein lies the problem.

If it's that easy, why doesn't everyone do it? The size of the carry trade is estimated at US$500 billion or more, so you could argue that the herd is already fully exposed. The big risk in any carry trade is the uncertainty of foreign-exchange rates. Since the most frequently mentioned carry trade is the yen carry trade, let's focus on that.

The recent low against the dollar was 122 yen. The yen subsequently strengthened from 122 to 115 _ roughly 6% in less than 10 days. Just imagine what the Bank of Thailand would do if the baht were to go from 36 to 33.80 in a similar time period.

Why the knee-jerk reaction in global markets over the past two weeks? Actually, most global markets and especially those in Asia, excluding Thailand of course, had tremendous runs over the past three months (China +46%, HK +13%, Singapore +15% and Dow +5%). No wonder the Shanghai Composite fell 9% in one day and triggered a global sell-off in equities. Feb 27 also saw the yen appreciating more than 2.5%. In the next three days, it hit a high of 115.

Now, back to the yen carry trade. The theory is as follows: sophisticated investors are borrowing yen and not only locking in higher yields in US or Australian dollars, but using these proceeds to speculate in emerging markets and volatile global commodity plays. It would be reckless to guesstimate at what exchange rate these carry trades were put on _ 112 or 120 yen, it may be somewhat irrelevant. Generally, a depreciating yen is good for carry trades and a strengthening yen is bad. If the forex exposure is unhedged or a directional view is taken on the currency, the leverage could make losses severe.

Is the yen carry trade really the cause of global market mayhem? Partly so, but not entirely. Two recent cases, May 2006 and October 1998, were significant market events involving the yen carry trade. From 1995 to 1998, the yen depreciated around 80%. This culminated in the yen reversing and rallying 20% in two months as the carry traders would down positions. Ironically, Long Term Capital Management went bust along with the Russian debt default. As markets fell in reaction to LTCM and Russia, yen carry trades were hit hard.

In May 2006, the yen actually rallied 7%, then markets reacted and sold off. Clearly this is a chicken-and-egg scenario whereby the yen can trigger market events, be blamed unnecessarily or exacerbate market volatility.

Former US Federal Reserve chairman Alan Greenspan said recently that the yen carry trade was still going strong but ''at some point it's got to turn''.

It appears that the carry trade will live on as long as there are massive differentials in global interest rates, particularly in developed countries. If the former Fed chairman is right, global markets are in for a serious correction; at what ''point ''is anybody's guess.

Brian Hoegee is Managing Director, Asia, of Global Trader, a leading London-based derivatives provider registered with the Thai SEC. Contact him in Bangkok at 0-2625-3120 or visit www.gt247.com
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Quote from Jaxon:

Nice article. Too bad the Bankok Post only keeps their articles online for one day! I had to dig pretty deep to find the article in a cached page. I would like to see the Fed do a study to determine to what extent low global rates (Primarily Yen, but also Euro) are responsible for keeping US Treasury rates unusually low. The market has developed convenient excuses to explain the negative yield curve, mainly that there is an implicit forecast of a recession and Fed rate cuts in the future, but the real reason could be that many investors actually find a 4.5% yield high relative to funding costs.
More...

Thanks for finding the article, I had no idea it would be hard to get to!

This is what I think: if the yen is strengthening and the US is anticipating a rate cut then the yen carry will slow down drastically. Due to losses, markets are starting to sell off. Yen carry gets paid off, which strengthens the Yen further, and creates more selling off in the markets and more severe market declines. Once US rates are cut to balance the sell off, this causes more of a slow down in yen carry, again causing the markets to drop… cyclical behavior which will affect any market the Yen carry is related to. Currencies strengthen; investors and brokers take capital losses, leading to more selling. This will further cause other repercussions in the markets such as lack of liquidity, recessions and effects on commodities like gold and oil.
 
It is only a matter of time before the yen appreciates. But predicting when is a folly. Because you have had a very long trend down for over a decade this market will not turn on a dime- look at gold for example - it had been in decline for a long time
http://www.the-privateer.com/chart/usgmonth.html
Gold gave investors the heads up to its impending explosion upwards, in 99 but it took another 2 years to finally go on its current bull run. In the meantime the smart money including GS and JPM who were permabears toward gold had time to cover positions.

Will they have time to cover their yen positions? Who knows. This time they might get caught out due to the extreme differential in asset valuations between japan and non japan, and the sheer speed that the hedge funds switch strategies and with the huge leverage that they have been utilizing.
If a rapid shift out of US RE finds its way into Japan via repatriation and external investment, then not only is the carry trade over, but so is the major source of cheap credit that has been keeping the US RE market booming way beyond normal cyclical time constraints
 
More interesting stuff from Reuters South Africa:

http://za.today.reuters.com/news/Ne...26_RTRIDST_0_OZABS-MARKETS-FOREX-20070315.XML

"LONDON (Reuters) - The yen's broad rally against other major currencies paused on Thursday as a recovery in global stock markets made investors slightly more comfortable about yen-funded carry trades.

U.S. producer prices, capital flows and factory data, all due for release later in the session, will be in focus given the recent rise in risk aversion was in part prompted by concerns about the health of the world's largest economy.

Sharp falls in equity markets had quelled risk appetite and made currency investors less keen to borrow low-yielding currencies like the yen to fund investments in higher return units like sterling or the dollar.

Now, a recovery in shares has prompted some to go back into carry trades, which still look attractive from a yield perspective -- Japanese rates are just 0.5 percent compared to 5.25 in Britain and 7.5 percent in New Zealand.

"The main driver (for currencies) is not fundamental issues, it's really driven by risk aversion, the equity market performance," said Mitul Kotecha, head of FX strategy at Calyon.

"The fact that yesterday we had a bit of a gain in U.S. equities, and a stronger performance in Asian equities overnight helps reduce risk aversion slightly and the yen has come under a bit of pressure as the volatility of carry trades continues."

European stocks opened around 1 percent higher on Thursday, after similar scaled gains in Tokyo's Nikkei index overnight and gains on Wall Street on Wednesday.

By 0840 GMT, the dollar was up 0.1 percent at 117.17 yen and the euro was steady at 154.81 yen.

Sterling, which had been a key beneficiary of carry trades and has thus suffered more than some of the other currencies during their unwinding, stabilised at 226.51 yen.

The euro ticked down to $1.3205.

DATA, CENTRAL BANKS

Euro zone February inflation data are due at 1000 GMT with the year-on-year rate expected to be confirmed at 1.8 percent.

European Central Bank Governing Council member Klaus Liebscher said on Thursday that euro zone monetary policy remained relaxed given strong economic growth and that he saw inflationary risk rising towards the end of this year.

Fellow Governing Council member Nicholas Garganas said the bank was determined to act promptly to monitor price stability.

The ECB is expected to raise rates to 4 percent in coming months but has signalled that policy may be nearing its peak.

Thursday features two central bank decisions, with the Norges Bank expected to raise rates to 4 percent and the Swiss National Bank seen hiking to 2.25 percent, both at 1300 GMT.

In the U.S., February producer prices are due at 1230 GMT, followed by January net capital inflows numbers at 1300 GMT and the Philadelphia Fed's survey of March factory activity in the U.S. Mid-Atlantic region at 1600 GMT.

Any signs of weakness in the data could boost expectations of a Federal Reserve rate cut later this year, and would probably lead to a fresh bout of risk aversion.

"A combination of weak activity and high inflation data is probably the worst outcome for equities and related high beta markets such as emerging market currencies," BNP Paribas said in a research note.

Investors will also be looking for any more news from U.S. subprime mortgage lenders, amid concern that trouble in that sector could spill out in to the wider housing market."
 
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