Feature Stories | Jun 15 2006
By Greg Peel
"The entire global financial system is on the verge of disintegration, as the result of the imminent collapse of the yen carry trade." Daily Telegraph (UK), 24th February.
"The multiplier effect of the blowout of the carry trade is going to mean that the crisis hits with a magnitude far beyond any individual nation or currency. This will bring down the whole post-Bretton Woods floating exchange rate system." Lyndon LaRouche, political economist, same day.
Blog after blog on the net, whether respected or otherwise, have gone into overdrive this year in anticipation of events that will see an unwinding of the yen carry trade. As the sample of opinions above attest to, such a development is not being taken with a pinch of salt. What, then, is the yen carry trade?
About three months ago, the Bank of Japan made an historic announcement: it was prepared to start raising interest rates shortly, maybe even as early as June. In the scheme of things, this hardly seems momentous, given just about every nation’s central bank, from the US to Australia, through Europe, Asia, South America and beyond, has turned to policies of monetary tightening recently in order to ward off the effects of global inflation. In Japan’s case, however, there is definitely a fundamental difference.
It has been described, in fact, as "a pivotal moment in modern financial history". The reason is that Japan is the second biggest economy in the world, and Japan’s short term interest rates have been as good as 0% all of this century. It is past Japanese monetary policy that has given rise to the yen carry trade.
Effectively, the Bank of Japan (BOJ) was handing out free money. Its intention was to bring Japan out of a decade of deflationary depression, and spur on Japanese bank investment. The reality was, however, that the BOJ became the bank to the world. Global investors could borrow money at less than one percent and then invest in US treasuries at increasingly higher interest rates. Provided the currency remained relatively stable, and the BOJ constantly intervened to see that it did, investors were laughing all the way to the bank. It was as good as a free profit.
And it didn’t stop at US treasuries. A few points of spread will never be enough if other opportunities are available. Thus bond markets in high cash-rate countries such as New Zealand, Brazil, Australia and even Iceland became depositories for the free money. Why stop at bond markets? Real estate, from London to Shanghai to Sydney to Miami became a target. High risk emerging markets offering substantial returns are less of a risk if your cost of funds is negligible.
Then came the China phenomenon. Suddenly commodities were on the move and the super cycle thesis was born. Gold started to climb as well, with particular attention being given to new forms of speculative gold investment available as listed finds. Forget jewellery demand and global tension. Experienced gold watchers around the world were shaking their heads in disbelief at the weight of pure investment money hitting the metal. As China surged, similar base metal investment vehicles were introduced. Suddenly all the world was a speculator.
Global stock markets were also moving. Investors poured into commodity-backed bourses as metal price increases drove earnings increases which drove share prices from miners to truck tyre manufacturers. Australian mining analysts were floored. Against every fibre of their being and all their life experience they could only continually re-rate Australian mining stocks on the back of raging spot prices.
Although demand/supply fundamentals were clearly a force behind the commodity rally, the pure hysteria of the rally was put down to a matter of sheer liquidity. Since the US has tried to restart its economy after the tech crash, and Europe needed to spur on growth, money has been cheap and the world has been, as so many commentators have noted, "awash with liquidity". And nowhere was money cheaper than in Japan.
Banks, mutual funds, insurance groups, pension funds and hedge funds the world over have exploited the availability of liquidity, and exploited the yen carry trade. No asset class has been left out, as speculative bubbles have developed in emerging markets, metals, gold, real estate, art – you name it.
David Bloom, currency analyst at HSBC has said that the yen carry trade has every single instrument imaginable, so when it comes to an end at the end of this year "it’s going to be ugly". Why will it come to an end? It’s all about QE and ZIRP.
The BOJ has for years maintained monetary polices of quantitative easing (QE) and a zero interest rate policy (ZIRP). Quantitative easing has meant that the BOJ has excessively printed money in order to defeat the deflation that has cast a pall over the Japanese economy for nearly two decades. The zero interest rate policy was intended to provide an impetus for domestic investment, as previously noted.
Japan has begun to see light at the end of the tunnel. As a result, QE has ended. Next step is the end of ZIRP, which commentators are expecting to happen anytime soon. This will mean the free money will no longer be free, and that means the spread between funds borrowed and potential return will narrow. It also means the yen will be allowed to rally against the US dollar beyond the previous range of interventory control by the BOJ. This will serve to diminish, or even wipe out, carry trade profits.
The doomsayers suggest that the end of ZIRP and a subsequent rally in the yen will trigger a cascading speculative sell-off in every asset previously subject to the liquidity bubble. Foremost in their minds is the fact that this has actually happened before.
Back in 1998, hedge funds were still a relatively new concept. But hedge funds that were around at the time had poured into yen carry trades with a specific target in mind. Since the fall of the Berlin Wall, Russian debt had taken on junk bond status. Spectacular returns were to be had by buying Russian debt at silly yields and financing with almost zero yen borrowings. As long as the debt was ultimately honoured, it was a bet to nothing.
Problem was, Russia defaulted. Massive paper profits became massive crystallised losses overnight. Speculators climbed over each other to pay back their yen exposures and the yen rallied 20% in less than two months. One of the US’ biggest hedge funds, Long Term Capital Management, collapsed with billions owed to a string of respectable US investment banks. The Fed had to step in and prevent financial catastrophe by shoring up the system with cash. Otherwise the domino effect may have seen the collapse of the whole world financial system.
At the time, the powers that be in Washington, Tokyo and Berlin were all but oblivious to what had been happening. What is the yen carry trade? How big is it? How much leverage is involved? Hedge funds suddenly became something of the evil empire. Legislate against them! was the cry.
Obviously the world has learnt from1998. Are you kidding? No way! Here we are again.
This time, the yen carry trade is not just the exclusive domain of a handful of large hedge funds. It is the domain of hundreds of hedge funds, large and small, and of mutual funds, managed funds, pension funds and individual investors. Funds come under the restriction of all sorts of legislation, disclosure requirement, and risk management necessity. It is hard to see a repeat of the debacle of 1998. Or is it?
In March this year, two weeks after the announcement by the BOJ that ZIRP may soon be lifted, credit-rating service Fitch downgraded the sovereign debt of Iceland. Iceland had been running short term rates as high as 10.75% and as such had attracted plenty of interest from yen carry traders.
Iceland’s stock market plunged 20% in one day. The Icelandic krona fell 8% in two days. Reverberations were felt as far away as New Zealand, South Africa, Hungary and Brazil as attention turned to other high-yielding currencies. Australia also came under scrutiny and the Aussie started to slide.
This event, as well as the Russian experience, has been held up by doomsayers as evidence that the financial world is on a precipice.
Fueeling the fear is the fact that nobody knows exactly just how big the yen carry trade is. The BOJ doesn’t know. Nor does the Fed, the World Bank or the IMF. Estimates range from hundreds of billions (of US dollars) to trillions.
Popular blogger Michael "Mish" Shedlock has been republished all across the web with his publication last week of "Nightmare Carry Trade Scenario". Shedlock argues that the perfect storm of events that would spell potential financial disaster would be (1) the end of QE, (2), the end of ZIRP, (3), rising interest rates in Europe, (4) falling interest rates in the US, (5) tightening credit in the US and (6) a rising yen against the US dollar.
(1) is done, (2) is set to happen, (3) is happening. (4) is clearly not happening, and (5) has not yet showed signs of happening. (6) will happen as a result of (1), (2) and particularly (4).
While the Fed appears hell-bent on continuing to raise rates to avoid inflation, it would seem the yen carry trade into US dollar assets is intact. If anything, over sixteen Fed rate hikes it has no doubt expanded. But the US economy appears to be slowing, and the belief is that it will continue to slow. The Fed is fighting inflation for now and is prepared to deal with that problem while leaving the US economy problem for another day. However, the market assumes that Fed tightening must eventually stop.
When it stops, it will likely be due to core inflation not being as rampant as the hawkish Bernanke is anticipating. Many economists shrug off hyperinflation fears as misplaced. But then attention will turn to a sluggish US economy, and the next move in rates will be down. That will trigger (4) and (6). In theory, credit should not tighten in the US if rates are falling, but Shedlock throws up the potential scenario of a falling housing market, subsequent defaults, and a refusal by mortgage lenders to shift rates down as a protection against more failures.
Thus we would achieve Shedlock’s "nightmare scenario" and perhaps LaRouche’s collapse of the whole floating exchange rate system.
Or is that being overly hysterical?
LaRouche added to his statement with "Let it happen. The system is doomed under any circumstances, and we know what must be done to create a new, stable financial system, based on the principles of Franklin Roosevelt’s original Bretton Woods System. I am ready with a recipe for precisely how to solve this crisis. Are you?"
Doesn’t sound like Lyndon’s made too much money lately, or is he simply nostalgic?
Stephen Roach, chief economist at Morgan Stanley, has weighed into the argument: "The lure of the carry trade is so compelling, it creates artificial demand for ‘carryable’ assets that has the potential to turn normal asset price appreciation into bubble-like proportions. History tells us that carry trades end when central bank tightening cycle begins."
As possibly the greatest financial bear of our time, Roach’s comments must be taken in context, but his point is clear and evidential: we have experienced asset bubbles, and the carry trade must end when tightening begins. It has begun.
Which brings us to an obvious point. Is the correction we have been witnessing actually a manifestation of carry trade unwinding already? We have experienced blow-off tops in base metals, gold, and world stock markets. While there are bears roaming the woods there is still a general feel that this is simply a healthy correction in a long running bull market. The feeling is also, however, that it has further to run yet.
Let’s look at some realities. The first obvious bale out asset is US treasuries. This will affect a falling US dollar and a rising yen (to repay the loans). Firstly, Japan may be about to end ZIRP, but is it about to let its currency appreciate rapidly overnight after a decade in the economic wilderness? Unlikely. The great savers of the world, including Japan and China, have a lot of funds invested in US treasuries (hence the global imbalance problem). Is it in anyone’s interest to thus let the US dollar collapse? An orderly fall seems more attractive.
Furthermore, a manic sell-off of US treasuries will mean the price of US treasuries will fall. This means their yield goes up. In the face of carry trade unwinding, this is a self-correcting mechanism.
Carry trade fear-mongers also predict the collapse of gold. This is counterintuitive. Gold has now fallen, in a hurry, from the highs it established earlier in the year (in a hurry). Most of the selling has been attributed to shaky longs getting out. It is eminently possible that carry traders were very much part of the sell-off. But if the US dollar falls, as the prediction goes, gold must rise. If the world’s financial system is teetering investors turn to gold.
Triggers for the gold sell-off were obvious. Apart from running too hard too quickly, Fed talk of further rate hikes means support for the US dollar which is bearish for gold. Simultaneously, tensions between the US and Iran appeared to be easing. Again, gold is a haven in times of trouble. Is the war on terror over?
China has indicated that it would like to, carefully, shift its reserves away from just US dollar assets and into other currencies, and gold. Russia advocates the same policy. As the US dollar begins to weaken, this will be a common thread.
Now the commodity boom. Again we have experienced a correction. Again we have seen hot money depart in a hurry. Carry traders? Quite possibly. Is it the trickle that starts the flood?
Well that would only be the case if you dismiss China and India as fly-by-nighters. There is a very real demand for commodities and a very real lack of supply that is struggling to catch up. Wherever commodity prices fall they will be met eventually with demand coming the other way. Whether or not you subscribe to the super cycle thesis (and most resources analysts do) there is a floor under commodity prices.
Dan Norcini is a Texan commodity trader and blogger. Norcini makes another obvious point, one that plenty of analysts have made when concerns are raised about the US current account deficit. If everyone bales out of the US dollar, where will all the money go? A redistribution must occur, suggesting there cannot be a simultaneous meltdown of all known assets. This carry trade is a global phenomenon, not an isolated incident like that of Russian debt. The money must go somewhere. (Norcini likes the idea of gold and base metals).
The global financial system is in better shape than it was in 1998. For the first time in a decade, the economies of the US, Europe and Japan are growing in synch. There is strong growth in China, South East Asia, India and Japan. The Australian economy is growing. The US can slow, China can slow, others can slow but there is a long way to slow. Global recession does not appear at hand.
Hedge fund might have become a dirty word after LTCM but that has not stopped hedge funds growing exponentially. Hundreds of them. Enough of that risk is now spread around a great deal more. And if the yen carry trade ceases to be viable is that the end of it? The BOJ may have financed the world recently but it’s not the only source of funds.
Mark Watts of Morley Fund Management believes the world will move into an era of greater differentiation of carry trades rather than all out reversal. "Fundamentals, as they are prone to do", says Watts, "snap back into focus eventually". There are a number of "pots of liquidity" that are less dependent on rising rates and will need to find a home. Watts cites the foreign exchange reserves of Asia and OPEC as examples, as well as one area that has been largely overlooked – simple corporate cash.
We are currently experiencing a period of great volatility in financial markets. Is it unprecedented? Absolutely nowhere near it. Present implied volatility in the Australian share price index futures is, for example, around 20%. Prior to the crash of ’87 it was 30%, and after it was 100%. Some volatility jumps into the 40% area have been experienced since, but generally volatility has been on a long, slow decline over the decades. 20% is nothing, and yet the market has been bouncing around suggesting much higher levels. Implied volatility is the risk value ascribed by derivative traders to an asset. Clearly derivatives traders are not panicked.
The reasons implied volatility has declined are many, not the least of which is the evolution of sophisticated derivative markets and the know-how to trade them. A whole generation of hedge fund traders have hit the market since even 1998. The securitisation of assets has continued a-pace such that the universe of investment instruments is vastly wider than it was in that last great crash.
Some observers, of course, blame this very point. Too many hedge funds, too many speculators, too much to speculate on and not enough reality. But the capitalist market cannot be restricted. It would be like restricting the human brain. The diversification of assets only supports the diversification of risk. It also supports leverage, and that is very much part of the carry trade fear. It is leverage that provides for the rollercoaster ride, but leverage, too, is quelled by risk management techniques.
Lastly, in this world of rapid communication, in this global marketplace, is not information disseminated in virtual zero time? For months there has been speculation of the end of ZIRP. Has the world sat on its hands, closed its eyes, and hoped it will go away? I doubt it. Talk of the yen carry trade has also been around for a long time. The correction we are experiencing may well be more about the unwinding of the carry trade than simple inflation fear. It is a chain reaction: inflation means interest rate rise means unwinding positions means end of bubbles. But is it the end of the world as we know it?
The yen carry trade will be around for some time yet, and it will have to come to an end. As to whether it comes to an abrupt, and devastating, end, is another case in point.