This story,”Carry trade returns,” comes from the Financial Times’ John Authers. For those new to the term, the “carry trade” in simple terms is when investors borrow in a currency with low interest rates (in this case, the yen) and use the proceeds to make investments in countries where the prevailing interest rates are high (Australia, New Zealand, or for the more conservative, the US).
The risk is that the currency in which you’ve borrowed appreciates, wiping out the difference between your low borrowing rate and your higher investment return. Many believe that the unwinding of the carry trade played into the market correction a few weeks ago (investors sold assets in countries with high return investments so they could repay their yen borrowing).
As we discussed, the yen did not appreciate as much as many feared (unwinding carry trades leads to buying of yen, which makes the price rise) because it turns out Japanese retail investors are bigger participants in the carry trade than foreign speculators. For example, Japanese banks and securities firms offer foreign currency savings accounts. And when the yen appreciates, they buy more foreign assets, which means they sell yen, which counteracts the foreign speculators’ yen purchases.
So per Authers, investors, realizing they are less exposed to a sudden yen appreciation (the big risk in this practice) due to the preponderance of Japanese investors that will sell yen when the currency rises, have understandable gone back as before (if not more so):
Carry on regardless? Amid much hubbub, it looks as though foreign exchange traders’ much-vaunted “carry trade” – the practice of borrowing in a low-yielding currency such as the Japanese yen and sinking the funds into a high-yielding one such as the New Zealand or Australian dollar – is coming back….
Carry trade cash is widely perceived as an important support for the valuations of other assets. This is probably overstated but markets have worked on this belief, with equities tightly correlated to shifts in the yen.
Why might the carry trade return? The Bank of Japan’s decision to keep interest rates at their low level, and to douse speculation that they would rise soon, certainly helps. So did the surprise in the UK inflation data, which increased the chances of rate rises from the Bank of England, thereby strengthened sterling.
The turmoil in forex markets is not over. The yen rose sharply on Tuesday after reports that the People’s Bank of China would diversify some of its huge holdings of dollars. But this was not accompanied by a sell-off in US equities, so the high correlations between asset classes while uncertainty was at its peak are receding again.
Equity traders are less worried about the carry trade than a week ago. History supports them. Alan Ruskin of RBS Greenwich Capital shows that compared with past shake-outs, the fall in global equities has already been bigger than in previous episodes. The bulk of the sell-off in equities, after the past five times a carry trade was rudely interrupted, was over within 15 trading days – a point we have now reached.