Yen Carry Trade Not Over Yet

The yen-carry trade received a lot of attention a few months back as the BoJ ended its quantitative easing policy and just last month raised its short-term target interest rate for the first time in six years. The draining of capital liquidity is at least partially being blamed for a global equity sell-off in May in conjunction with a Fed rate hike. Nevertheless, the BoJ has said it will "gradually" raise rates with no intention of doing so "consecutively," which has brought the yen carry trade back into fashion.

Chris Young of the IHT wrote about the situation in Japan where still very low interest rates and wide interest rate gaps with other major economies is resulting in weakness in the yen.

So far in August (as of last Friday) the yen has weakened as follows against these currencies:

$NZ -5.0%

$CAN -3.2%

£ -3.2%

R$ -3.2%

Mex$ -2.3%

$US -2.2%

€ -2.1%

In terms of rate spreads, Japan's 0.25% rate is considerably lower than:

ECB 3.0%

Canada 4.25%

US 5.25%

Mexico 7.0%

Brazil 14.75%

For the investor in Japanese equities a weaker yen brings mixed results since it results in underperformance of ADRs, ETFs, and mutual funds versus ordinary shares, but at the same time it actually helps ordinary shares because of investor sentiment and eventually if/when firms repatriate profits (and report foreign exchange profits in earnings releases). Long investors will eventually benefit when the BoJ resumes its rate hikes and central banks around the world slow or end theirs'.

Comments

[pascal jean...:]

Yes yen carry trade is back with a vengeance which is normal considering the Yen/$ rate differential which you mentionned and Yen carry trade is obviously a factor impeding further Yen appreciation.
In fact the keyword for traders to engrave in their mind is Yen FOREX implied volatility, when Yen FX volatility goes down so does the Yen. Since mid august the Yen FX rate
Volatility has been low at 7 - 8 %. (114 - 117 against $). Due to this low volatility rate US hedge funds have quickly embarked again on Yen carry trade operations. On the other hand when the Yen volatility is high then rate differential gain disappears and hedge funds run away.
BOJ ZIRP end kick started Yen strength as hedge funds stopped to carry trade the Japanese currency however the US/Japan rate differential status quo since led to the quick resurgence of Yen carry trade.
CME Yen futures were sold again on the 29th of august and actually reached a historic high for volume on that very day. Of course yen carry trade capital is geared to so called High Yield currencies (euro, GBP, AU$, NZ$ etc...) but also this capital feeds BRICS stock markets substantially and commodities markets also. Provided Japanese rates and Yen volatility do not shoot up hedge funds will keep on carry trade the Yen.


This said I do not share (at all) the categorical view of Enzio Von Pfeil: think twice!
Japanese base money (high powered money) is quickly being drawn by BOJ therefore Yen in circulation will go down even if Japanese base rates do not appreciate. Also I would be extremely careful in over asserting that the Yen volatility will stay low forever.

True a weak Yen maybe somewhat problematic for foreign investors investing in Japanese equities but I do believe that for foreign investors capital gain appreciation in Japan is much more important than potential currency loss.
And finally as I am a convinced monetarist fan for Japan herself the benefits of having a relatively weak currency plus an expanding economy largely outweight this. When inflation is not a worrying factor (not yet) a weak currency is godsent.

2006 Sep 11 01:07 PM

[Steven Towns:]

Pascal, thanks for providing us with a deeper look at the implications of the yen exchange rate and the carry trade. For the average non-Japanese investor I tend to agree with your statement that "for foreign investors capital gain appreciation in Japan is much more important than potential currency loss." In fact, I believe for longer-term Japan investors there is the dual benefit (assuming cap gains) of winning when the yen strengthens more permanently as the rate gap narrows with say the US$ and euro. I expect this narrowing to begin from as early as spring '07, standing by my prediction that a second rate hike will not happen this calendar year.

For those interested see Pascal's latest Japan Investment newsletter.

2006 Sep 12 10:22 PM