Weakening Yen Poses Risk to Carry Trade

While this topic may seem a bit esoteric to some readers, it is just about the most simple-minded trade in the financial markets, which is precisely why so many players are involved in it. You borrow in a currency that has low prevailing interest rates, like the yen, and invest in instruments in a currency where the money market and short term bonds are paying high interest rates, like Australia.

And the short side of the trade, the one in which you are a borrower, looks even better if the currency is weakening. Not only do you pay very little in interest, but you get to pay back less principal than you borrowed. What’s not to like?’

The problem is that everyone seems to be keen on this trade, too keen. The yen has been getting weaker since the Japanese central bank decided not to raise interest rates, and there is now considerable short interest in the currency. As you may know, a large short interest is often considered a bullish sign, since if the market moves at all against the shorts (as in, the yen appreciates), the parties with short positions need to buy to cover their shorts, propelling the market further upwards.

This Financial Times article, “Falling Yen sparks carry trade alert,” points out a scary bit of deja vu. A rapid appreciation in the yen in the wake of the Russian crisis helped precipitate the meltdown of Long Term Capital Management. That debacle threatened the financial system, but proved to be manageable because crisis revolved around one massive player, and all its major counterparties were gathered in a room to devise a bail-out. If we have a similar rapid change, it won’t be one huge player that collapses, but several (many?) smaller ones, and therefore much more questionable that the damage could be contained.

The yen hit a four-year low against the US dollar on Monday, intensifying fears that the rising level of currency-based “carry trades” by hedge fund investors could jolt markets if these positions were suddenly unwound.

The Japanese currency’s sharp fall also prompted European finance ministers to voice concern about its weakness.

Jean-Claude Juncker, the chairman of the eurozone’s 13 finance ministers, said he was “increasingly a little bit worried” about the yen.

The currency dropped to a record low of Y158.60 to the euro last week. On Monday, it fell to Y122.19 against the dollar.

Many economists and bankers suspect that carry trade activity is an important factor behind the yen’s weakness.

Carry trades are deals in which investors borrow in currencies with low interest rates, such as the yen and the Swiss franc, to invest in those that pay higher rates, such as the Australian dollar.

According to Barclays Capital, speculative carry trades have reached their highest level since the Russian crisis in 1998.

It estimates that these amount to $34bn in net terms, calculated in constant 1998 prices for the yen, Swiss franc, sterling and Australian dollar.

The scale of the carry trade – and its concentration in the yen – is raising fears among policymakers that a rapid unwinding of these trades could shake financial markets.

Figures from the Commodities Futures Trading Commission last week indicated that there was a record level of “short” yen positions in the market – trades that bet on further yen weakness.

This trade has produced fat profits for hedge funds in recent months as the yen has weakened and interest rate expectations have remained low.

However, the outlook for the Japanese economy is improving and there are expectations that interest rates could rise this year.

These events could potentially undermine the rationale behind the carry trade, prompting a rapid shift in positions.

Such a shift occurred during the 1998 Russian crisis, when the yen suddenly rose from Y147 to Y112 in a matter of days, helping to trigger the near collapse of Long Term Capital Management, the US hedge fund.

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