Update: Read The carry trade: a tsunami in the making more insight into the risks facing the carry trade.
The end of of the yen carry trade could be devastating for capital markets throughout the world. Experts estimate that there are several hundred billion dollars of positions in the carry trade to be unwound. David Bloom, currency analyst at HSBC, says that it has pervaded “every single instrument imaginable”, so that when it comes to an end later this year it’s going to be “ugly”.
Many people will now be nodding their heads sagely, perhaps as they did when they were told that it was responsible for driving financial markets higher.
But what is the yen carry trade? Put simply, it is borrowing at low interest rates in yen and using the loan to buy higher yielding assets elsewhere. During the past decade, the trade has become a “staple” for many investors, says William Pesek Jr on Bloomberg. Perhaps the most popular form of the strategy exploits the gap between US and Japanese yields. Anyone borrowing for next to nothing in yen and putting the money into US Treasuries (US government bonds) has received a double pay-off: from an interest rate difference of more than three percentage points and from the dollar’s rise against the yen. Investors make their profit when they reverse the trade and pay back the yen loan.
However, monetary authorities throughout the world are now midway through a process of normalising interest rates, which had been slashed to support growth after the dotcom bubble burst in 2000, says the Financial Times. Britain is furthest down this track, with interest rates steady at 4.5% and inflation at 2%. The US is not far behind, with nominal rates already matching the UK and set to go higher. The tightening cycle in the eurozone may be put on hold, but not for long. Japan is a laggard – it is just approaching the “starting line”, with the country only just returning to steady growth, which might (or might not) lead to a halt to monetary easing in April and an end to zero interest rates by the end of this year. An end to Japan’s zero interest rate policy might lead to yen appreciation (low interest rates usually mean a weak currency), and so an end to those benign, “no brainer” conditions that have justified the ‘carry trade’ and been so supportive of other asset classes. Borrowing would become more expensive and foreign exchange risk would be higher.
And it’s not just Japan. The eurozone, Sweden and Switzerland have already turned off the tap of ultra-cheap credit, says Ambrose Evans-Pritchard in The Daily Telegraph. But Japan is by far and away the most important. Already, signs of panic are appearing in markets: last week, the Icelandic króna “crashed” 8% in two days, after rating agency Fitch downgraded Iceland’s sovereign debt. The high-yielding currencies of New Zealand, Australia, South Africa, Hungary and Brazil followed, as nervous investors removed their cash.
Something similar has happened before. Eight years ago, panic in the global financial markets sent the yen surging 20% in less than two months and other markets collapsed, particularly emerging markets, as investors rushed to repay their yen. Then, as Japan’s economy worsened, the trade became popular once again.
This time, an announcement by the Japanese central bank governor that Japan’s growth rate was an annualised 5.5% in the fourth quarter of 2005 indicates that the country is finally coming to the end of seven years of deflation. Hence the central bank will act “immediately’’ to tighten its monetary policy, preparing the way for rate rises “above zero” in coming months.
So, seven years of cheap credit for speculators and investors is coming to an end. And as Jonathan Allum, strategist at broker KBC, says, the fallout is “potentially endless”. It could lead to the serial collapse of speculative bubbles all over the world, including high-yielding and second-tier currencies, trophy real estate, high-yielding bonds, art and possibly even gold. Are there any beneficiaries in this scenario? While there is undoubtedly some speculative money in them, Allum believes that the fundamental, economic case for commodities remains “intact”.
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