This is part 2 of Focus on Currencies. Focus on Currencies (part 1) covered Technical Analysis, Politics, and the Commitment of Traders report (speculation vs. hedging) of futures. Part two covers the carry trade and currency fundamentals.
The Carry Trade
Let’s kick this section off with the question: What is the carry trade?
The answer comes from the San Francisco Fed in an article entitled Interest Rates, Carry Trades, and Exchange Rate Movements.
What is the carry trade?
In the most common version of this strategy, an investor borrows a given amount in a low-interest rate currency (the “funding” currency), converts the funds into a high-interest-rate currency (the “target” currency) and lends the resulting amount in the target currency at the higher interest rate.
According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the “uncovered interest parity,” the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.
In practice, however, investors in international financial markets do seem able to make profits through such strategies.
Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts. Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate.This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.
In reference to the COT numbers on the Yen from part 1 … The numbers might seem huge, after all $13,212,986,904 bet on shorting Yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Sester’s excellent article A trillion dollars gets my attention, whether it comes from the PBoC or the yen carry trade.
Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets.
I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.
Just how large the carry trade is, nobody really knows … But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.
After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.
There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.
Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back.
That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.
A private investor might even want to start to take some profits ….
Bottom line: a ton of people — the Japanese government and Japanese “real money” as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.
In September of 2006 MarketThoughts.com had an interesting article called The Yen Carry Trade Revisited.
……The second great Yen carry trade began in the summer of 1995 and it did not end until October 1998 – when the Yen ended its decline by rising 15% in a week!
As for the current Yen carry trade, there is little evidence to believe that much of the borrowed Yen went into commodity speculation – as the decline of commodity prices in the last four months has generally not led to a higher Yen. More likely, the typical profile of the latest Yen carry trade participant is as follows:
1. A speculator who borrows or shorts Yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., UK, or countries in the Euro Zone. The days of using this money to invest in higher-yielding countries in “peripheral” developed countries like Iceland and New Zealand has definitely ended – given the crash in both of these currencies earlier this year.
2. A Japanese investor (e.g. a pension fund, a life insurer, or an individual investor) who converts his money from Yen to U.S. dollars (or the Euro or the Pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged – which again puts further pressure on the Yen.
Quoting the IMF’s “Financial Stability Report”:
The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors—particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1 percent of GDP.
Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006. (Mish note: Speculators are hugely short Yen futures again as discussed above)
So the $64 trillion question is this: When will the Yen carry trade end? On a purchasing power parity basis, the Yen is undervalued against the U.S. Dollar, but massively undervalued against the Euro. That being said, things can always get more extreme before reversing – especially when it comes to the financial markets. Drawing a tentative up trend line from the previous lows in the Yen in early 1990, October 1998, and early 2002, and one gets a target range of approximately US$0.78 to US$0.82 (for every 100 Yen) before we see the Yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78 to US$0.82 range and my preferred timeframe (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play starting January 1, 2007. Historically, a goods & services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different – despite the prevalent optimism among the German government at this point.
So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question: When will the Yen carry trade end?” is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the Yen (as noted in part one and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in part 1 in reference to the COT data (i.e. an unwinding of the futures positions is dollar negative on balance).
Yen / US Dollar (Monthly)
- All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there.
- Gold has never gone to zero and barring a star trek like replication device, or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero either.
- In the meantime the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and Foreign Direct Investment. The much ballyhooed trade deficit is far down the list.
- When it comes to the Yen, the interest rate differential between Japan and the US or Japan and Great Britain is substantial.
- Japan is also sitting on a national debt over150% of GDP. What that will eventually do to interest payments when rates rise should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is Yen negative.
- Europe has demographic problems of its own. Europe also has a very rapid expansion of M3 but a much lower interest rate than the US. That is Euro negative vs. the US dollar.
- Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound as expected rate hikes in the UK may not occur.
Everyone has a tendency to look at problems in the US in isolation. As you can see the issues are both many and complex. There is a lot more to currencies than the one sided view often heard “The US dollar sucks”. This post is an attempt to look at things from as many angles as possible.
From a purely technical standpoint I would have to suggest “Trust the trendline breaks on the charts”. From the standpoint of things almost always get crazier than anyone thinks, I am inclined to believe the Yen is likely to sink further then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade one should be watching those charts carefully.
From a political standpoint I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully”. From the standpoint of the US dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.
Two Quick Notes:
- This post originally appeared in Whiskey & Gunpowder.
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