What happens to the yen and carry trades?
The yen stays weak so carry trades continue – until there is a violent spasm in credit markets.
Interest rates and thus the yen stays weak because
- The domestic economy remains tepid, what with China taking more jobs and demographics skewing the labour force
- Politically, there are Upper House elections looming, so no politician wants rates to be hiked before an election.
- Remember that in Japan, and to a degree in all of Asia, policy making is “tribal” in nature: everyone gets to be included!
- As the recent G7 summit showed, global politicians are not too worried about the weak Japanese interest rates and thus the weak yen
- Rates get to stay weak because liquidity policy remains very tight: base money keeps contracting by an annual 20% - this plunge has been going on since February 2006, so for nearly a year! No need to raise rates if you are decimating the monetary base…
So how large are these carry trades?
- According to The Economist of 10th February, nobody knows. They say –
- There is USD 200bn worth of short term net foreign lending to Japanese banks, and
- More revealingly, that the “net short positions on the Chicago Mercantile Exchange” are as high as USD 1 trillion.
What will cause carry trades to unwind and thus for the yen to strengthen?
- Cuing off the same Economist article , but adding my variation, it traditionally has been volatility in CREDIT (not currency!) markets that has made hedge funds unwind their positions – and this has driven up the yen
- Here is an historical example using CEIC Data:
- In May 1995, the yen was at its strongest: 83/US dollar.
- By July, 1998, the yen had fallen to 144/dollar. That represents a 42% plunge! Part of this plunge was due to carry trades
- After Russia’s default in August, and after the subsequent near collapse of Long Term Capital Management, hedge funds got scared and unwound their carry trades rapidly – and in October, the Japanese government announced its plans to re-capitalise its crippled banks. The result is that by November, 1999, the yen had risen from the 144 mark back in July 1998 to 102/dollar, or by 41%
Expect a re-run, but this time perhaps coming from America’s sub-prime home mortgage lenders, for instance? My point is that it is NOT currency volatility that causes hedge funds to unwind their carry trades: currency volatility is a SYMPTOM, not a cause! The CAUSE of such unwinding is volatility in the underlying credit markets that makes hedge funds get scared, so they flee uncertainty by unwinding carry trades – and thus are forced to buy yen to repay their yen borrowings.
Any currency in particular that you are observing against the yen?
· In terms of a longer term cycle, the latest bout of yen weakness began in May 2006, when the yen stood at 112/dollar. Now it is around the 120/dollar, or 7% weaker
· Curiously, the Thai baht rose by over 6% against the US dollar during the same period.
· Thus, since last May, the yen has fallen most against the baht – by around 13%!!
So what is the investment implication of the yen falling most against the baht?
· Expect the yen to start rising against the baht. It just seems as if the Thai government has many challenges to face – from unrest in the south to some of its extremely capable advisers leaving… So my guess is that foreign investors will seek more promising pastures – and exit Thailand. That capital outflow has to drag the baht down with it- driving up the yen against the baht.
More generally, next to pronounced credit market volatility, what else will drive up the yen?
· The received market wisdom is that the yen rises when Japanese rates rise.
· I don’t see much scope for Japanese rates rising strongly for a long, long time: the underlying economy and demographics and the attraction of China as a manufacturing base are simply too strong – besides which, the politicians’ and bureaucrats’ “tribe” will disallow any pronounced rate hikes.
· But, once US, Euro and Sterling rates peak, then watch the relative attractiveness of the yen rise…
· I think that 2008 will see weaker US and European rates, and thus a stronger yen….
Any other Asian currency implications stemming from a weak yen this year?
- The clearest implication has to be that in Asia, the non-dollar block will seek to keep its exchange rates soft in line with the yen – so as to maintain export competitiveness against Japan.
- This suggests more selling of local currency, which in turn fuels an excess supply of money within the context of The Economic Clock®.
- That excess supply of money, in turn, bodes particularly well for non-dollar markets!
The following are notes by Dr. Enzio von Pfeil culled from his recent appearance on Bloomberg TV U.K. and Germany.