The following are notes by Dr. Enzio von Pfeil culled from his recent appearance on Bloomberg TV U.K. and Germany.
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!