Why The Yen Carry Trade Carries On Some More

The ¥/US$ exchange rate has serious implications for U.S. and non-Japanese investors buying Japanese ADRs, ETFs and other funds. Foreign currency acts like a double-edged sword because, for instance, a weak yen helps the likes of Japanese exporters, but hurts their overseas stock listings and related funds.

Below are some reasons why I think the yen-carry trade will live on despite growing speculation that an unwinding is approaching with potentially dangerous side effects.

It's anyone's guess how soon, or when the carry trade will wind down (or end), but my argument is that it will not be over the next few months, and if a blow-up or widespread selling in global currency and/or equity markets is to happen, then I see it happening later, rather than sooner.

One opposing idea I do have is, although global equity markets do not need any bad news at this time as many are at all-time, or multi-year highs, an unwinding of the yen carry trade could be a good source of blame for a correction.

Note as an investor a weak yen will be hurtful to one's Japan holdings. However, the end of the yen carry trade will result in a strong appreciation of the yen and thus, a nice boost to any Japan holdings. The issue is one of risk management and timing.

*Note: Japanese exchanges were closed today for "National Foundation Day."

1. A Bloomberg article last month by William Pesek said JP Morgan estimates the size of the carry trade to be about ¥40 trillion, or $331 billion, noting that is bigger than Australia's economy.

• Surely the number of players in the carry trade is broad, but like many things, action is likely concentrated among a select few such as top-tier i-banks, institutional investors and hedge funds.
• Smaller players may bail out on speculation of a Bank of Japan rate hike, or on any upward momentum with the yen, and there'll definitely be a lot of financial media coverage talking about the danger, however, the big players are enjoying the carry trade too much to want to end it sooner than it has to.

2. The Bank of Japan will not raise rates this month

• First, the BoJ can't raise rates now because it is obvious blue chip exporters are benefiting from the circumstances and exporters are still a key component of the economy.
• Second, the BoJ won't raise rates now because of pressure from the Japanese government due to the mountain of debt its under.
• Third, even strong GDP data from the most recent quarter will not be enough to convince the BoJ to implement a follow-on hike because wages are still not rising despite strong profit growth, and perhaps consequently, consumer spending is still sluggish. Note that should the yen rise, then profits at exporters will almost certainly fall, making it at least somewhat more difficult to raise wages than it is now.
• Fourth, the BoJ can't be hawkish, even though it's only potentially a 0.25% hike to 0.50% because of past bad experiences that are unforgotten.

3. The yen stays weak for other reasons

• Japanese individual and institutional investors desperately searching for yield, whether it be in savings accounts, bonds, or high dividend yield stocks, and most of these are found overseas, which means keeping more downward pressure on the yen.
• Even with a rate hike this or next month by the BoJ, the rate differential will still be sizable between Japan and the U.S. (0.5% vs. 5.25%)
• Incoming FDI remains significantly lower -- although it is a top concern for the Prime Minister to boost it -- than outflowing non-portfolio capital
• The Japanese economy has suffered enough -- a weak yen helps the economy as stated above
• A lesser factor, but important nonetheless, is because a not insignificant number of Japanese tourists travel every winter holiday and spring and summer holiday, and throughout the year for that matter, exchanging yen for foreign currencies

US$/¥ chart as of 02/09/2007:

Euro/¥ chart as of 02/09/2007:

Disclosure: The author owns iShares Japan call options, but does not own any "investment" positions in currency aside from personal savings in both US$ and yen.