Carry Trade Unwinding Worsening Market Upheaval

The Wall Street Journal discussed the role of the carry trade in Thursday’s issue, quoted below, and Friday’s Financial Times, pointing to overnight trading in Tokyo, says the situation is worsening.

The Economist and other financial publications have commented on the magnitude and risks of the carry trade, and how disruptive it could be if many firms had to reverse their positions quickly, and this scenario appears to be playing out.

In simple terms, investors, typically hedge funds, are borrowing in yen, a currency with very low funding costs, and investing in currencies where the interest rates are high, like the New Zealand or Australian dollar (although for some, even the US dollar is high enough). It has been likened to picking up nickels before a steamroller. If you are adept, you make what look like very easy profits, but if the currency (in this case, presumably the yen, since it is dramatically undervalued) moves against you, the currency losses could easily overwhelm the interest rate gains.

One sign of how overdone (and overdue for correction) the carry trade is: a colleague who does business in Russia and emerging markets told me that Czech housewives can fund mortgages in yen. Now get this: not only is someone willing to borrow yen to finance higher-yield Czech mortgages, but they managed to get the Czech borrowers to agree to take the currency risk (ie, the financial institutions are simply taking a spread). This is the sort of trade that won’t unwind (the poor Czech borrower will be killed when the yen moves against him), but the fact that someone bothered to turn this trade into a retail product says a lot about how hungry investors are for high-yield opportunities like the Czech mortgages.

We have seen very few mentions of the carry trade as a factor in the financial instability of this week until now (although there were some nervous comments about whether the appreciation of the yen this week could lead some funds to unwind their carry trades). But perhaps that is because there have been no fund failures (at least none as of yet), and because it’s hard to know what is a carry trade (the yen side is often done through derivatives, and the higher-interest-rate investments have been made in many different countries).

The Economist took a stab at the size of the carry trade activity in a story “Carry on living dangerously:”

Nobody really knows how big the carry trade is. Japanese official figures show little evidence of large net lending to foreigners. For much of 2006 Japan actually had a net inflow of bond investment. Estimates based on the short-term net foreign lending of Japanese banks put the carry trade at only $200 billion.

But hedge funds do not need to borrow yen and then buy higher-yielding currencies. Instead, the carry trade is typically done through transactions, such as currency forward swaps, that are off-balance-sheet and therefore do not show up in official statistics. A better clue comes from record net “short” positions in yen futures on the Chicago Mercantile Exchange. Estimates of the total size of the carry trade range as high as $1 trillion….

The Journal story, “‘Carry Trade’ Reverse Shift Helped Drive Tuesday’s Plunge,” says that further unwinding of carry trades could prolong the instability in the markets for another week or two:

One reason Tuesday’s plunge in global stocks happened so fast involved money that helped fuel their recent rise: super-low-cost funds from Japan.

From 2001 until July 2006, Japan’s central bank kept its benchmark short-term interest rate at zero, and even after a rate increase last week, the rate is only 0.5%. That compares with 5.25% in the U.S. and 3.5% in the euro zone. The difference has enabled investors to profit by borrowing money in yen to buy higher-yielding assets denominated in other currencies…. With so many investors selling yen, the growth of the carry trade helped push down the yen in recent months to its lowest level in years against major currencies. That makes the carry trade more attractive because a falling yen makes profits earned in other currencies worth more in comparison.

When concerns about the U.S. economy and overheated stock markets around the world helped trigger market drops Tuesday, investors say the unwinding of yen loans accelerated the declines. Market participants say it is likely that when some investors grew nervous, they began to sell their holdings in everything from Indian stocks to the Australian dollar and used the proceeds to buy yen to pay back their loans.

Investors’ rush to buy yen pushed up the value of the yen against the dollar by more than 2% on Tuesday. In New York yesterday, the dollar rebounded to 118.41 yen, up from 117.98 yen late Tuesday, but still below 120.57 yen the day before.

“Everything that happened was consistent” with the unwinding of carry trades, said Jay Bryson, global economist with Wachovia Corp. in Charlotte, N.C. “We had the Japanese yen strengthening and high-yielding currencies declining.

The Financial Times gives the latest, and more troubling, update, “Yen strength raises fears over carry trade.” Things have gotten so bad that Japanese officials, like Eisuke Sakakibara, are trying to talk the yen back down:

The Japanese yen on Friday headed for its biggest weekly gain against the dollar in 14 months, raising fears about the unravelling of the global carry trade….

The selling of equities appears to have been triggered by a strengthening of the yen. A stronger yen puts pressure on global carry trades, because it makes it less attractive to sell the low-yielding Japanese currency to buy higher-yielding assets in other currencies.

Some analysts have said that investors who faced losses in equities were closing profitable carry trade positions. As the Japanese yen strengthened, high-yielding currencies, including the New Zealand dollar and the South African, tumbled on Friday.

Japan’s currency has already gained almost 3 per cent this week, the biggest increase since late 2005, and was at 117.66 against the dollar in late trading in Tokyo on Friday. On Thursday, the yen reached 116.97 against the dollar, the highest since December 13, after rebounding from a four-year low of 122.19 at the end of January this year.

Eisuke Sakakibara, Japan’s former vice-finance minister once universally referred to as Mr Yen, said currency traders had long enjoyed an unusual period of stability, but that conditions “could change this year”.

However, he predicted that this week’s movement was not the start of carry trade unwinding, saying he expected the yen to trade within a Y115-Y120 range against the dollar for the rest of the year. “The carry trade is going to continue for some time and the weak yen tendency is not going to be reversed so quickly,” he said.

Mr Sakakibara said the Bank of Japan, which last week raised rates a notch to 0.5 per cent, could move again faster than markets expected, and that a rate rise as early as May was possible. However, he said that, as long as interest rate differentials with the rest of the world remained so high, a rapid unwinding of the trade was unlikely.

Hiroko Ota, economy minister, said the strengthening of the yen in the past few days would not have a substantial effect on the economy. The weakness of the yen, a by-product of low Japanese interest rates, has provided a significant boost to exporters, still the main engine of growth.

Meanwhile, the yen on Friday was headed for its biggest weekly gain against the UK pound since December 2005, trading at 230.47. It was on course for its biggest weekly rise in more than a year versus the Australian dollar, trading at 92.44. Against the New Zealand dollar, it stood at 81.59 and against the South African rand it stood at 31.3954. On the week, the yen has gained 4.8 per cent against the New Zealand dollar and 5.9 per cent against the South African rand.

Investors are likely to be on edge ahead of the opening of trading in European and US markets. Asian, European and US stock markets closed in negative territory on Thursday. The Japanese stock market continued to fall on Friday with the benchmark Nikkei average down nearly 1 per cent in afternoon trading – erasing all its gains for the year.