The yen carry trade is once again a hot topic in financial news, as the U.S. subprime induced liquidity crunch has rapidly spread fear of a collapse in bond and credit markets across the globe. Similar to the market turmoil this past late-February and early-March, Japanese equities have taken the worst beating with the Nikkei 225 Stock Average down 9.5% in August (through Aug. 17 market close) and 16.0% over the past month, while the broader TOPIX Index is down 11.0% and 16.7%, respectively.
“Yen carry trade” (円キャリー取引) refers to investors who borrow yen cheaply (consider the Bank of Japan’s target overnight lending rate is 0.5% as of Aug. 17) and invest the money overseas in higher yielding investments.
Japanese individual investors engage in the carry trade via specialized domestic investment trusts (mutual funds) and individual forex accounts, in order to capitalize on higher yielding currencies, such as in Australia (central bank target rate of 6.5%) and New Zealand (8.25%). Professional investors, meanwhile, could be investing in anything across the spectrum from bonds and equities to exotic derivatives.
Years of deflation have forced the Bank of Japan to maintain an extraordinarily accommodative monetary policy, resulting in comparatively high capital liquidity and low lending rates, both ideal for carry traders. These conditions are two of three key aspects of the carry trade. A third variable, currency stability, represents the biggest day-to-day risk, given the huge forex trading volume and price fluctuations.
At present, the yen carry trade is falling apart due to U.S. subprime market woes, which have spread fear of illiquidity and a flight to quality, globally. A double whammy for Japan, is the fact that the U.S. remains an important export market (consider the renewed fears of a U.S. economy slowdown) and exports are still a large component of the economy. Therefore, as market turmoil deepens, investors’ appetite for risk lessens, resulting in rapid price declines in equities. The downward pressure on Japanese equities is exacerbated by yen appreciation, which explains the substantial drop in the benchmark indices referenced above.
Nobody knows the exact size of the yen carry trade, with estimates among the world’s leading banks ranging from $300 billion to more than $1 trillion, but most economists and strategists share concern about the possible damage of a full unwinding. There are lot of stakeholders, perhaps the most important being the government of Japan and its citizens. It is the latter that receives the most attention, since due to the meager interest rates on cash deposits and comparatively low dividend yields on equities, Japanese individual investors have (increasingly) aggressively sought higher yielding investments overseas. Domestic money managers have been more than willing to accept such earmarked funds.
The yen has advanced sharply against a basket of major currencies in recent trading and dramatic swings have occurred against currencies with high interest rates. Liquidity concerns and risk reduction may keep heavy buy interest on the yen in the near-term. However, there are implied limits, because it is not in Japan’s best interest to have a strong yen, since exports will suffer. Furthermore, the Bank of Japan is in a predicament due to sluggish consumer price growth and spending, meaning any rate hike will likely be followed by a long pause. Also, hiking in 0.25% increments from 0.50% at present, hardly decreases global rate spreads, meaning Japanese investors will still be seeking higher yield overseas. Liquid foreign investors will also see an opportunity. I expect continued volatile forex trading, but project the low one-hundred-teens to become a level of stability. Japanese equities indices will likely remain range bound.
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