Time to eat a little crow. I had a few past posts worrying about the unwinding of the carry trade. Even though the yen has been moving upwards, and the financial press keeps citing the carry trade as a contributor to the turbulence in the markets, two sources I consider well informed, one John Dizard of the Financial Times, the other a senior Japanese financial executive who is personal friends with Mr. Yen, Eisuke Saikakibara, and also on a first name basis with executives at the Bank of Japan, both say in no uncertain terms that fears of the carry trade unwinding are overblown.
The Japanese expert argues that Japanese retail participation in the carry trade greatly exceeds that of hedge funds (banks and securities firms have multi-currency products that invest in higher-yielding foreign assets). And while hedge funds will buy yen when the currency appreciates (if the yen goes up too much, their currency losses can exceed the income on the interest differential), retail investors will buy more foreign investments (a higher yen makes for a more favorable time to buy). My source claims that when the yen went to 115 per dollar, retail investors took it back down to 118 (I seem to recall the BoJ intervened too, but perhaps they merely threatened to intervene).
What I found particularly interesting is that the powers that be in Japan think it’s a good thing for retirees to invest abroad. They need to earn income on their savings, and Japan’s low interest rates don’t offer any meaningful current yield. So for them, the carry trade is a bit of an annuity: they sacrifice some real value of principal in return for cash flow.
Dizard comes up with an estimate of total carry trade activity of about $170 billion identical to that of my Japanese expert, so I assume they are literally singing from the same hymnbook. By contrast, their estimates of hedge fund related activity within that total were very different ($10-20 billion from the Japanese source, $20-40 billion according to Dizard) but the difference doesn’t affect the conclusion.
It turns out a lot of pros read the situation (based on the same press reports, apparently) as I did earlier, anticipating yen appreciation, and bet accordingly. So at least I was in good company.
Below is Dizard’s story, “Cool profits from the hysterical nonsense over carry trade.” I’ll skip over his discussion of “risk reversal skews.”
There is such a thing as the carry trade, but it is not as large as it has been made out to be by talking heads, nor is it the cause of the present unease in financial markets. To gain some perspective, consider this: the Japanese ministry of finance and the Bank of Japan believe that short-term carry trade-related borrowings in the yen are equivalent to between $20bn and $40bn. When you add in the individual Japanese investors, the “real money” buyers of foreign currency-denominated securities, the total is, they believe on the close order of $170bn.
As the readers of these pages will know, the carry trade is the financing of a high-yielding asset, such as a US mortgage-backed security or an Australian dollar bond, with money borrowed in a low-yield currency, such as the Japanese yen or the Swiss franc. As long as the low yield currency does not increase much in relative value or see a rise in interest rate levels, the carry trader can capture a wide spread between the cost of borrowed money and the income from the financed asset.
Let us skip from primary to graduate school. How do you measure the risks of your short position in the borrowed currency? One way is to look at the long-term relative competitiveness of the country issuing the borrowed currency compared with the country of the invested currency. Logical, but it can take a long time for your logic to work. Assuming you are right about this fundamental judgment, though, you could still be wrong about how the market will price the relative values in the short run.
In the shorter term, the foreign exchange tribe measures how out of line a currency is through “risk reversal skews”….
What is the risk reversal skew in the Japanese yen telling us now? Well, as of last week, the skew was showing that people who had been listening to financial television commentators and reading weekly business magazines had been frantically buying call options on yen. Since, apparently, the end of the world was coming and the Japanese were about to stop lending yen, corporate treasurers and speculators had to get them at any price. The implied volatility of calls, which at the beginning of January had been about half a volatility point higher than puts, gapped out to about
1.7 volatility points by the beginning of March.
“That is the widest since March of 2004,” says Robert Sinche, a forex strategist with Bank of America. “If this had just been about the yen, the [market reaction] would have been more contained, but there was this perception that the yen carry trade was responsible for everything, including world hunger.”
This sort of over-reaction is more common towards the end of a market move, rather than at the beginning. Japanese officialdom, personified by Hiroshi Watanabe, the vice-minister of finance for international affairs, only weighed in with a warning about the carry trade towards the end of the mini-unwind, when he would have known the risks were already being discounted….
If there really were a collapse in the value of the dollar against the yen, which the hysterics on the television and on the forex customer lists were anticipating, then the ministry of finance would direct the Bank of Japan to buy dollars. They knew it was not necessary, since they could read the message of the risk reversal skews.
The market “correction” began because people realised that the adjusted numbers published on the US economy were not accurately recording the weakening of growth. All the talk of a carry trade unwind did, however, was to create an opportunity to buy some cheap yen puts against expensive yen calls.