FYI | Mar 13 2007
By Greg Peel
As the dust settles over the risk-based correction we’ve just experienced which many thought was overdue anyway, there is at least consensus that the Chinese stock market collapse was in itself insignificant – merely a little trigger for overstretched global markets. With that in mind the blame shifted to the unwinding of the yen carry trade, and this sent shivers down many a trader’s spine.
The market perception is that the world holds massive yen borrowings at low rates which have been invested in everything from gold to copper to Brazilian stock markets, New Zealand bonds and emerging corporate paper. These risk trades have fuelled global asset appreciation in the twenty-first century and crushed risk premiums to uncomfortably low levels. If this turns around, the world is going to hell in a handcart.
One estimate of the total stock of yen carry trades (there is no formal, reliable measure) from the Vice Minister for International Affairs of Japan’s Ministry of Finance, Mr Watanabe, is about US$150 billion.
Let’s put that in perspective, says Morgan Stanley’s London-based global economist Stephen Jen. In the first five days of the global correction, US$3 trillion in equity market capitalisation was wiped out. That’s a bit of an overreaction if it was sparked by fear of US$150 billion being unwound. The global equity market capitalisation stands at around US$43 trillion. On Mr Watanabe’s numbers this means the yen carry trade equates to a mere 0.36% of world equity value.
“Blaming the unwinding of the ‘JPY carry trades’ for causing havoc last week is almost as bad as blaming the sell-off on the Chinese equity markets”, says Jen, “To me, what happened in the last two weeks was the result of excess leverage, extreme mis-pricing in some markets and investors having the same trades. JPY shorts may have been a popular trade, but it is by no means a dominant position in the market, in my view”.
Another misconception, notes Jen, is that the yen carry trade is an activity only undertaken by hedge funds looking for the quick buck. However, the trade is “as much structural as cyclical”.
What this means is that if the carry trade were only cyclical, the implication is that money borrowed in yen for investment in various risk instruments is done so simply on the basis of the interest rate differential. Borrow at under 1% and invest in, for example, Aussie bonds at over 6%. (The risk lies not in the Aussie bond itself, it lies in the potential for the currencies to shift).
But this perception discounts the massive savings of an aging Japanese population which is simply looking for a return on its retirement funds. Returns on overseas equities have far exceeded simple interest rate differentials. This is a “structural” trade, where investors are chasing capital appreciation more so than any interest rate “arbitrage”.
Nevertheless, open interest at the International Monetary Market (futures exchange) in Chicago showed extremely high levels of short yen contracts (around 114,000 compared to the decade average of 30,000) which were then reduced by about half in the week of turmoil. This showed hedge funds in action, and explains the sudden jump in the yen against the US dollar. But at the same time, notes Jen, Japanese retail investors “have been remarkably calm”. Japanese institutional investors were in fact net buyers of dollars, not net sellers.
The conclusion is thus (a) the “unwinding” of the yen carry trade was only carried out by rattled hedge funds with overextended risk positions and (b) the buyers of yen have been foreign institutions not local ones. In terms of cause and effect, the equity sell-off prompted the currency adjustment, not the other way around.
“With the very positive global economic outlook and abundant global liquidity, I see risk-taking recovering rapidly from the latest correction, though there should be better differentiation between assets than in the past” Jen concludes. “In other words, this is a great opportunity for investors to ‘upgrade’ their portfolios”.
