This month, we focus on the yen carry trade: yes, that trade that hit so many hedge funds all bundled up in the same direction in early March. Brian Hoegee, managing director of Global Trader Asia, picks apart what the trade involves, whether it caused market turbulence and where to now for the yen and investors taking bets on it... Considering the volatility in global markets of late, pundits have been eagerly looking to blame someone or some event, and 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 for the downward move in prices.Interest rates have been at or around 0% in Japan since the early 1990s and the concept of 'carry trade' has been around for quite some time, but really started to come alive in the late 1980s. Carry trades are used by hedge funds and other traders seeking relatively risk-free yield. It is a strategy where an investor sells a currency with a low interest rate (for example, Japanese yen yielding just 0.25%) and uses the proceeds to purchase another currency at a higher yielding interest rate - dollars at 5.25% for example. 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 exchange rate - USD/JP¥ - stays constant. Therein lies the problem.If it is that easy, why doesn't everyone do it?The size of the carry trade is estimated upwards of $500bn, so it is clear a great number are doing it. Neither the Bank of Japan nor the Bank for International Settlements, however, can quantify the amount, but most say it's enormous.The magnitude of exposure and overall risk in any carry trade is the uncertainty of foreign exchange rates. The recent low against the dollar was ¥122 around the end of January and again in mid-February. The yen subsequently strengthened from 122 to 115 - roughly a 6% move in less than 10 days. Just imagine what the Bank of Thailand would do if the Thai Baht went from 36 to 33.80 in a similar time period…well, we actually have the answer to that…draconian exchange controls that rocked Thailand's SET Index to the tune of 15% down in just one day. Central bankers, especially those in emerging markets, sometimes don't fully grasp how linked their capital markets are to global monetary flows and the subsequent move in prices if policy is changed drastically.Why then markets' knee-jerk reaction over the past few weeks?Actually, most global markets and especially those in Asia, excluding Thailand, of course, had tremendous runs over the past three months (China: 46%, Hong Kong: 13%, Singapore: 15% and DOW: 5%). No wonder the Shanghai Composite fell 9% in one day and triggered a global sell-off in equities. On 27 February, the yen appreciated by more than 2.5%. Subsequently, over the next three days, it hit a high of 115.Now, back to the carry trade. The theory behind it is: 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 estimate at what exchange rate these carry trades were put on, ¥112 or ¥120, and it actually may be somewhat irrelevant. Generally, a depreciating yen is good for carry trades, a strengthening yen is bad. If the FX exposure is unhedged or a directional view is taken on the currency, the losses could be severe due to the leverage.Is the carry trade 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 by around 80%. This culminated in the yen reversing and rallying 20% in two months as the carry traders wound down positions. LTCM 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 more than 7% before 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.Dramatic movements in the Japanese yen itself can often cause the yen carry trade to unwind or further exacerbate the unwinding of the trade. A slumping stock market and horrible local real estate market forced many Japanese to repatriate their capital back to Japan. This repatriation of huge amounts of overseas investments by the Japanese (primarily in US real estate) during the late 1980s further compounded the yen's rise; it rose nearly 20% in 1990, 6% in 1991 and the yen carry trade came to an end in September 1992 when the UK was forced to exit the Exchange Rate Mechanism. This triggered steady appreciation of the yen, actually breaking ¥80 to the dollar in April of 1995, a level which has never been seen since. Former Federal Reserve Chairman, Alan Greenspan, said recently, the yen carry trade is still going strong but "at some point, it's got to turn."So is it going to turn?2007 does hold some similarities to 1998 - although Russia, China and other emerging markets are in a much better financial state than nine years ago. Leverage is being applied through the use of credit derivatives, there is a dramatic rise in appetite for risk and complacency, it seems, is rampant - especially in the current commodities run.What would the consequences be?A massive unwinding of the yen carry trade would certainly rock the markets, but to what extent, nobody really knows. For certain, US Treasuries will become less desirable as yen carry traders unwind their long US Treasury positions.The yen could rally to 100 or higher, while the dollar would continue to weaken against most major currencies. Real estate, commodities, and equities, which globally have all been flush with liquidity, could come under serious selling pressure as margin calls contribute to further selling.Such consequences can be severe. Just ask Julian Robertson's Tiger Fund, which allegedly lost $2bn in just 48 hours when forced to unravel trades carried in yen. Other funds certainly felt the pain and after the Long Term Capital Management collapse, Alan Greenspan felt the world was facing a global credit crunch - soon after, the Federal Reserve cut rates by 75bps.Times are, however, a bit different today. One can imagine the spiral effect if Fed Chairman Ben Bernanke had to step in to cut rates - the dollar would fall even further than it already has.Merrill Lynch stated recently that the yen will strengthen to around 107 by the end of September. Reference to the point that low-yielding currencies are in a current fiscal mode of tightening will add to the pressure. The Swiss Central Bank just raised rates by 25bps to 2.25% and has the lowest rates of any developed nation besides Japan. Clearly, most believe the yen is undervalued at current levels.The recent low of ¥122 to the dollar and the subsequent move to ¥115 clearly showed that the performance of global markets is linked to the yen carry trade in some capacity. As the dust settled, carry-trade currencies such as the New Zealand dollar began to appreciate again, while the Japanese yen and Swiss franc depreciated against the dollar with the yen steadying at around ¥117-¥118. Compounding this were recent reports out of the UK that inflation may be worse than expected, adding pressure to the Bank of England for rate increases.In the end, however, it appears that the carry will live on as long as there are massive differentials in global interest rates, particularly in developed countries such as Japan, the United States and Australia.If the former Federal Reserve chairman, probably the most respected central banker ever, is right, global markets are in for a serious correction; at what 'point' is anybody's guess. Watch the swings of the Japanese yen for clues....
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