This has been an all-round bad news sort of day. And of the bad news, the most troubling is that the carry trade is unwinding.
For those of you not familiar with this phenomenon, it consists of borrowing in currencies that have low interest rates and then investing the proceeds in countries and assets that offer higher returns. It’s been compared to picking up nickels in front of a steamroller, because if the currency you are borrowing in appreciates, you have to pay back more than you borrowed, which can wipe out any profits on your clever investment strategy.
The currency at the center of the carry trade is the yen due to its near zero interest rates. Many observers (yours truly included) incorrectly expected the carry trade to unravel in the volatile markets of early March, as hedge funds covered their positions. Otherwise, they risked being caught in the currency version of a short squeeze.
But lo and behold, Japanese retail investors turned out to be even bigger players than the hedge funds. And when the yen went up, that meant it had even more buying power in foreign currency terms. So they’d sell yen, driving the currency back down.
This situation led to considerable handwringing. The carry trade has become so massive that it had become a major source of global liquidity (even the retail traders are leveraged, using margin accounts to hold down positions considerably in excess of the capital they have put at risk). Yet the Japanese authorities were unwilling to intervene, because the strategy was, until recently, profitable and popular.
While we haven’t yet heard from Mrs. Wantanabe (the prototypical Japanese retail currency trader), it appears that Japanese investors are dumping their foreign positions due to the market turmoil (New Zealand and Australia were particularly popular, but the US was on the list as well). As Bloomberg tells us:
The yen advanced the most against the dollar since 1998 as a global rout of stocks and credit markets pushed investors to sell riskier assets funded by loans in Japan.
The yen is the strongest most-actively traded currency today as the carry trades unwound. Global stocks tumbled and companies from Australia to Canada sought emergency funds as they were unable to refinance debt. The last time the carry trade crashed was in 1998 after Russia’s debt default in August. The yen gained 20 percent in less than two months.
“The market is in panic mode,” said Michael Woolfolk, senior currency strategist at the Bank of New York Mellon in New York, the world’s largest custodian bank with over $20 trillion in assets under administration. “It is a full-blown unwinding of the carry trade. This is just the beginning.”
The currency was up to as high as 112 yen against the dollar, It wasn’t that long ago that it was stuck in the 122-123 range. This is a serious move and is likely to lead to new-found caution in Japan.
And how bad could it get? Tim Lee, an economist, gave a very grim view in a comment in the Financial Times
Ultimately there must be a sharp convergence of exchange rates with fair values, inflicting heavy losses on carry trades. The size of the global carry trade is at least $1,500bn and losses from a convergence of currencies with fair values could total about $550bn with most of these losses accruing to leveraged speculators.
Given the close linkages between markets, we can be confident that the unprecedented deviations of currencies from fair value resulting from the carry trade are reflected in credit, equities and real estate markets.
For the US, this is confirmed in the ratio of personal sector net worth to GDP. Prior to 1995, this ratio tended to fluctuate at about an average of 3.4. Now, despite the paucity of savings in the US economy, the ratio stands at 4.1. A return to the long-run average would imply a fall in US personal net worth of approximately $10,000bn. With similar trends mirrored across much of the world, total global losses from the coming financial meltdown could easily reach $25,000bn to $30,000bn.
Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK and the euro area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.