Is the party over for the yen carry trade ? http://www.reuters.com/article/reutersEdge/idUSN2746285420070227
Tue Feb 27, 2007
By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - The party for yen "carry trades" may be ending sooner than expected, after a 9.0 percent slump in Chinese stocks on Tuesday prompted investors to reduce some risk in their leveraged portfolios.
The Japanese yen jumped more than 1.5 percent against the U.S. dollar, and was up about 1.0 percent against the euro on Tuesday, as investors unwound trades in which they had borrowed yen at low interest rates and used the proceeds to invest in higher-yielding assets in other currencies.
The yen had slid to a four-year low against the dollar in January, as low Japanese interest rates and low volatility in global financial markets, resulted in the "carry trade" value soar to an estimated $1 trillion.
The Bank of Japan's decision last week to raise its benchmark interest rate to a decade-high of 0.5 percent did little to restrain investors from selling the yen and buying instruments with higher yields, until now. Tim Lee, founder and president of Pi Economics, an investment advisory firm in Stamford, Connecticut, said the end of the carry trade regime could be a "devastating financial collapse."
"We would be seeing a lot of hedge funds and investment banks which have benefited from carry trades go under. When these trades reverse, they all reverse together and the yen is a crucial part of it," he added. Analysts say the warning signs have been evident for the last few weeks.
The market's extreme positioning on yen carry trades, defaults in the U.S. subprime mortgage market, and geopolitical worries about a potential confrontation between the U.S. and Iran, have been unnerving some investors, and have helped to push the price of gold up to a seven-month high of $689.00 an ounce this week.
With capital outflows from Japan intensifying this year due to a surge in retirement payments which are expected to be invested overseas, some strategists predicted an even lower yen against the dollar by the end of the first quarter. Bank of America, for instance, has revised upward its forecast for the dollar against the yen to 122 from 120 by the end of the first quarter.
But some analysts warned that these yen transactions cannot carry on much longer.
"Playing the short-yen, long-dollar trade isn't the no-brainer it's made out to be," said Avery Shenfeld, chief economist at CIBC World Markets in Toronto.
"A modest exchange rate move can easily wipe out the difference in yields. After all, a four percent annual interest gap implies only a fraction of that over a month," he added.
The differential between U.S. and Japanese interest rates is about 4.75 percentage points, with the federal funds rate currently at 5.25 percent.
US SUBPRIME MORTGAGE UNWINDING
Recent defaults in the U.S. subprime mortgage market for borrowers who can't get standard loans to buy homes because of low income or tarnished credit may be the first crack in the carry's veneer, analysts said.
The U.S. housing market slowdown has hit subprime borrowers as a sharp decline in home prices since 2005 has limited the ability of homeowners with little equity to refinance or sell their property. About 20 lenders in the U.S. subprime mortgage market have gone out of business in recent months.
"The subprime mortgage market, I think, is going to get worse and worse and there's no turning around," said Pi Economics' Lee. "The broader market seems to be ignoring it and that's a mistake. I think it's the first crack in the credit bubble."
The growth in subprime lending in the U.S. was fueled by a flood of global liquidity chasing higher returns in an environment of relatively low interest rates in the developed world, helped by sharply rising house prices in many countries.
As a result some lenders eased loan requirements on everything from houses to multibillion-dollar office buildings and introduced variable rate and deferred interest mortgages.
Analysts are concerned troubles in the subprime mortgage market could spread to other asset classes such as credit derivatives whose rapid growth have also been financed by low-yielding currencies such as the yen.
In the longer term, slowing economies in high-interest rate countries such as Britain and Australia may dim the attraction of carry trades also. Britain's interest rates are currently at 5.25 percent, while Australia's are 6.25 percent,
"Economic data offer signs the string of recent rate hikes in the UK and Australia are starting to slow growth momentum," wrote Sophia Drossos, currency strategist, at Morgan Stanley in New York.
That should convince their central banks to keep interest rates steady or cut them if growth slows dramatically, curbing their yield advantage and diminishing carry returns.
By contrast, Japan's domestic economy has showed signs of life and its surging trade surplus should support the view that Japanese rates will rise further.
Finally, a further risk for carry trades is that so many investors have put on the same trade, meaning there could be a rush for the exits that will exaggerate price movements.
"The yen has already cheapened enough to allow inflation pressures to return. In that case, the central bank may have to tighten policy a lot more," said Chen Zhao, managing editor of BCA Research's Global Investment Strategy bulletin in Montreal.
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