Feature Stories | Jun 26 2007
By Greg Peel
When the Chinese stock market fell 9% in March it sparked a month-long correction in many asset classes across the globe, including everything from stocks to gold. The 9% fall in itself was not as significant as the wake-up call it triggered, which caused investors to reassess positions in more risky trades. The sub-prime mortgage market was one of the first to go as investors took stock of historically low credit spreads brought about by excess global liquidity. The sub-prime scare was quickly accompanied by a rapid unwinding of the yen carry trade.
In February-March the yen “rallied” from 122 yen to the US dollar to 115. (Note: the yen is quoted as USD/JPY as opposed to the Aussie which is quoted as AUD/USD or, if you like, upside down). At the same time the Aussie fell from around US$0.80 to around US$0.77. These movements were reflective of an unwinding of the yen carry trade.
Now that US investment bank Bear Stearns has sparked the second major US sub-prime mortgage scare, will the yen carry trade follow suit once more?
What is the yen carry trade? (More knowledgeable readers may wish to skip ahead).
The term “carry trade” is derived from an old market expression known as “cash and carry”. Cash and carry refers most simply to the notion that you can buy goods from a retailer at a margin, or alternatively buy goods from a wholesaler for “cash” and then “carry” them away yourself. As long as the transport cost, or “cost of carry”, was less than the retail margin then you are ahead. The derivation lies in a neutral US selling arms to Britain and France at the beginning of World War II, provided those countries arranged to come and pick them up.
The “cost of carry” concept was then applied to commodity markets. For example, if you use a lot of copper in your manufacturing business you may prefer to buy your copper in bulk and store it in a warehouse for future consumption, rather than continuously buying as needed at spot prices. In so doing you protect yourself from volatile spot price movements. However, there is still a cost to you of funding that stockpiled copper while it’s not being used, and of paying for the warehouse space and so forth. So while you have paid “cash” for your copper at spot, you still incur “carry” costs until such time as you actually use the metal.
This is the reason why commodities such as copper typically trade in “backwardation”, meaning the forward price for delivery next month is lower than the spot price, due to carry cost considerations. If you consider that there is a “spread” between the price of copper now and the price of copper in the future then you can equate this to a spread in the price of borrowing money from a bank today (the interest rate) and the price achieved by “lending” the money into the future (such as by buying ten-year bonds). The difference represents a “cost of carry”.
The cost of carry of borrowing money and investing it in bonds within the boundaries of one economy is such that there is no opportunity to profit from a “carry trade”. Otherwise everyone would do it. At present the cash rate in Australia, for example, is 6.25% and the ten year bond yield about the same. No opportunity there. However, it’s a different situation when you start crossing borders.
A weak economy needs low interest rates to stimulate enterprise and investment in economic growth. A strong economy needs high interest rates to control growth and ward off currency inflation. Japan’s economy has been weak for years while Australia’s has been strong. Thus there is an interest rate differential.
This provides the opportunity to borrow in yen (sell Japanese bonds) and invest in Aussie (buy Australian bonds) and make a profit. This is an example of a “yen carry trade”.
The carry trade in turn pushes the relative value of the yen down and the Aussie dollar up. This window of opportunity should only last as long as it takes for the relevant economies to adjust back again. The result of lower rates should be that Japan is stimulated, spending increases, inflation is introduced, rates rise and the currency rises too. The result of higher rates should be that Australia is curbed, spending slows, inflation falls, rates fall and so does the currency. The window of opportunity to profit on a carry trade should quickly snap shut.
But it’s never quite as simple as that.
The Japanese are serial non-spenders. Over the last twenty years they have saved billions. Australians are serial spenders. Over the last twenty years they have gone into debt spending billions.
Japan has no natural resources. It survives on manufacturing. Australia has an abundance of natural resources. Its manufacturing industry struggles to compete. Thus Japan buys resources from Australia which it then turns into manufactured goods to sell back again.
This little relationship should mean an even balance in exchange rates, but don’t forget that Japan saves while Australia spends. Thus Japan suffers zero inflation and Australia is battling against rising inflation which maintains the interest rate differential and maintains the currency differential. And hence maintains the carry trade.
Now open up the game to the rest of the world and we find the greatest spenders of all – the Americans- and another great nation of savers – the Chinese- and another imbalance of the haves and have nots when it comes to natural resources which all in turn leads to the Great Global Imbalance that allows the yen carry trade to just keep keeping on. China artificially maintains a low exchange rate and thus low interest rates in order to support its export market. The US buys all the exports and runs up a debt. The US has a massive current account deficit balanced out by surpluses in the likes of Japan and China. Japan and China invest their surpluses in safe US bonds which in turn funds US spending. This little relationship keeps currency levels stable, and thus keeps the carry trade window open.
(There is no “yuan carry trade” simply because foreigners cannot borrow in China.)
Australia is not the only beneficiary of yen investment. On the one hand, the US provides a carry trade differential as it’s supposedly the world’s safest economy to invest in and US rates have been hiked seventeen times. On the other hand, even higher yielding currencies are popular, such as the Kiwi. At 8.00%, New Zealand’s rate is one of the highest in the world for a mature economy. So strong has the Kiwi been, exacerbated by the yen carry trade, that the RBNZ recently tried (unsuccessfully) to sell NZ dollars into the market to settle things down. Many other currencies have found yen-backed buyers, including those as obscure as the Iceland kroner.
And it is not just a matter of investing in sovereign bonds. Yen carry traders can use cheap funds to invest in everything from stock markets to commodities to gold to collateralised debt obligations. The yen carry trade is one way excess liquidity is being distributed across the globe.
Thus the fear is that global asset prices are supported by a house of cards. As the extent of the yen carry trade increases the risk is that the merry-go-round will eventually stop. When this happens, the reversing trade will precipitate throughout all markets. There could be carnage. It would potentially only take a small change in perceived risk in one instrument, a bit of profit taking or reversing of the trade, and the floodgates could open in panic. The last occurrence of an element of panic was in February when the US sub-prime mortgage scare occurred.
The reason a sub-prime mortgage scare could set off yen carry trade unwinding is (a) because there are hedge funds that have borrowed in yen and invested in collateralised debt obligations featuring securitised sub-prime mortgages and (b) any collapse in price in these instruments has implications for all risky investments if the yen carry trade begins to turn. The implication is that risk spreads are just too low.
There are commentators out there who believe the yen carry trade represents the potential for the financial end of the world as we know it. (See “The End Of The World As We Know It If The Yen Carry Trade Is Unwound”; Sell&Buyology; 15/06/06)
The US sub-prime mortgage market is in trouble again. Bear Stearns has just bailed out one hedge fund for $3.2 billion with another US$6 billion fund about to fall. This will force investors to price down their sub-prime holdings and possibly to jump ship. Some of that investment may be supported by yen borrowings, but either way if the risk price adjustment in the sub-prime market precipitates through all risky assets then there could be some more serious reversal of carry trade positions, as there was in February.
What will happen this time?
The first thing to consider is that the scare did not last long earlier this year, and after about a month it was business as usual. The carry trade has only been revved up ever since. So much so that the yen is now trading at about 124 to the US dollar – a four-and-a-half-year low (while the Aussie is pushing US$0.85 – a seventeen-year high). The second thing to consider is the yen has continued to fall even as the sub-prime mortgage situation has developed and worsened, leading to a sudden sell-off in US equities. Is this just denial? Or is it a case of “we panicked for no reason last time”?
Danske Bank notes:
“As has been the case on several occasions the death of the carry trade again proved exaggerated. Initially, the carry drawdown in early February stood out in a historical context by the speed and the extent of the drawdown during the first couple of days of the episode. Subsequently, the turn-around was faster than normal and carry performance has been even better than could have been expected. The cumulative return on a G10 carry strategy since the bottom in early March has been an impressive 12%”
Typically, the yen carry trade underperforms when bond markets have jumped and equity markets have felt jittery. But this is exactly what is happening now with no effect.
While currencies can be valued using interest rate differentials, another way to look at them is in terms of purchasing power parity (PPP). Put very simply, this measures the relevant cost of a litre of milk in different countries. On a PPP basis, notes Danske Bank, the US dollar is currently 26% overvalued to the yen. The euro is more than 40% overvalued. And the ultimate G10 carry trade – yen to Kiwi – is 45% out of whack.
Commonsense, and experience, would suggest that the carry trade should have turned around by now. Since 1980, the euro, for example, had never exceeded a 20% PPP differential to the yen (using an implied pre-2002 euro). It broke out in 2005 and has hardly looked back. Says Danske:
“But PPP – estimates or economic growth or current account surpluses for that matter – are less relevant for currency markets at the moment. As we have written several times, yield differentials and capital flows are what matters. NZD/JPY is a case in point. NZD/JPY has risen a full 37% during the last year or so a period where the two-year swap spread has increased by more than 1 percentage-point and now stands above 7%.”
What is more relevant, funnily enough, is the milk itself. As a major dairy producer, New Zealand’s economy has surged along with global dairy prices, forcing the RBNZ to lift interest rates. In Australia’s case, we have iron ore, coal and other commodities. What Danske is saying is that within the increasingly globalised world, trade imbalances exist between those who are suppliers and those who are consumers. This has allowed the yen carry trade to carry on. Add to that the imbalance between the savers and the spenders.
The latter is very much a consideration when contemplating whether the yen carry trade may collapse. The serial fear mongers of the world would have us believe that the carry trade is simply the preserve of hedge funds – those oft denigrated institutions that make money simply by moving money around. They represent the real house of cards. However, this is not the case.
The greatest carry traders in the world are Mr & Mrs Takashimi – the everyday Japanese middle class. Remember that Japanese interest rates have been zero for years. In that environment, how do you invest for retirement? What’s the use of superannuation that never grows? And the Japanese, unlike Australians, have an embedded culture of saving. Hence there is an awful lot of surplus pension fund capital looking for something better than a zero return. The answer? Invest offshore.
It is for this reason that Japan’s top financial diplomat, Hiroshi Watanabe, has recently expressed his lack of concern about the yen carry trade. “It is difficult to see a hasty unwinding of Japanese households’ huge investments overseas”, he noted . He added that estimations of the size of the carry trade currently exceeding US$1 trillion were exaggerated. However, he did suggest central banks keep a close watch on developments. The reality is that Japan is not overly thrilled with being the honey pot for everyone else to make money. Japan is widely expected to take interest rates from 0.50% to 0.75% soon. While Watanabe cites a gradual return to domestic inflation after years of deflation, most analysts suggest this would simply be a carry trade slowing ploy.
Danske Bank is not expecting the carry trade to suddenly collapse. It would not be surprised, however, if it suffered a correction of sorts given (a) the very sharp fall in the yen recently, (b) Japan’s intention to raise rates and (c) the activities of, for example, the RBNZ in trying to stabilise the Kiwi (it is unlikely New Zealand would raise rates again).
Danske views were expressed before the Bear Stearns crisis broke. A shift in sub-prime mortgage prices might be just what could trigger such a carry trade correction. But it hasn’t happened yet, if ever it will. In the meantime, currencies such as the Aussie are looking at sustained high levels. If the RBA sees fit to raise rates the level will be higher still.
The sub-prime scare has set off weakness in equity markets, precipitating through to Australia. Resource stock analysts are typically tardy in adjusting their currency expectations, suggesting there is a round of such adjustment to come. This would reduce resource stock earnings forecasts which, again, would affect weakness in the Australian equity market. A correction in the carry trade would reduce the Aussie dollar and thus offset such earnings revaluations, but it also might be very scary for equity markets in general.
Or maybe there won’t be a correction at all.
