Is The Carry Trade a Thing of the Past?

Even as global stock markets endured their worst week in four years last week, the Japanese yen shot up 3.7%. While most investors would have been happy to be invested in any asset that went up, a small army of hedge funds are making highly leveraged bets on the "carry trade" -- a trade driven by the gap between the low interest rates in Japan and higher rates in the rest of the world. And, those hedge funds saw a year's worth of profits evaporate almost overnight.

The Trade of the Decade: The "Carry Trade"

The "carry trade" is the code name for the financial sleight of hand that has been a license for global traders to print money over the past few years. If U.S. households used their houses as ATMs -- taking equity out of their homes to prop up profligate consumption -- global traders used the yen like a low interest credit card to finance their investments elsewhere. With Japanese interest rates at 0.5%, and interest rates in the United States at 5.25%, traders borrowed billions in yen, and invested billions into U.S. treasuries.

Critics suggest that the carry trade amplifies already serious distortions in the global economy. By artificially pumping up global liquidity, the carry trade helps inflate asset-price bubbles across the world, making it easier for the U.S., Britain and Australia to finance their large current-account deficits.

Economic theory tells us that the carry trade shouldn't even happen. The difference in interest rates between two countries should be equal, adjusted for the rate at which investors expect the low-interest-rate currency (the yen), to rise against the high-interest-rate one (the dollar). Perversely, the carry trade turned this logic upside down. The more speculators entered into the yen carry trade, the more they sold the yen. This caused the yen to fall, not to rise. Rather than correct the distortions, it only amplified them.

Surprisingly, no one really knows just how big the carry trade is. Official Japanese statistics suggest that for much of 2006 Japan actually had a net inflow of bond investment -- which would imply that the carry trade was a collective figment of the world's financial imagination. More helpfully, a leading Japanese official last week estimated conservatively that the carry trade was worth between $80 billion and $160 billion.

The carry trade is likely to be many times this size. Few financial institutions actually borrow yen to buy higher-yielding currencies. Hedge funds execute the carry trade through complex financial transactions, such as currency forward swaps. Because these trades are off-balance-sheet transactions, they do not show up in official statistics. A better estimate of the size of the carry trade is the record of net "short" positions in yen futures on the Chicago Mercantile Exchange. This puts the total size of the carry trade as high as $1 trillion.

The Trade Of the Decade: Is the Party Over?

The carry trade depends on one thing: a cheap yen. But with the yen rallying sharply last week, it may be coming to an end. Here's why.

First, the yen is already the most undervalued currency in the world. Since the collapse of the Japanese asset bubble in the late 1980s, Japan's economy has been recovering slowly -- thanks in large part to the Bank of Japan's extremely low interest rate policy. This has caused the yen to become remarkably undervalued. Indeed, the yen hit an all-time low against the Euro last month, and its trade-weighted value was at its lowest since 1970. According to the Economist's Big Mac Index -- which I recently analyzed -- the yen is undervalued by approximately 28%. At some point, this imbalance must be corrected and the yen has to rise.

Second, recent economic news from Japan has sounded the death knell for Japan's free money policy. With annualized Q4 GDP expected to be revised to 5.1% from 4.8% (that's more than twice the rate of U.S. GDP growth), Japan's economy is no longer flat on its back. The Bank of Japan is likely to raise interest rates more aggressively from now on. And higher Japanese interest rates mean a rallying yen.

Third, conventional wisdom once held that yen carry trades will continue as long as the Bank of Japan raises rates only slowly. This changed abruptly last week. A sudden, unexpected jump in volatility was sufficient for many traders to close out their highly leveraged positions by buying yen, causing the Japanese currency to appreciate sharply.

This is not without precedent. When hedge funds unwound their yen-financed positions after Russia defaulted on its debt in 1998, the yen skyrocketed by 20% in two months. Then in October, when the Japanese government announced a plan to recapitalize its crippled banks, the yen jumped another 13% within three days. Hedge funds suffered punishing losses.

The Trade of the Decade: Hedge Fund Hurt

You'd think that most hedge funds would have used complex trading strategies to hedge against a jump in volatility or a sharp appreciation in the yen. Not so. With pressure on hedge funds to generate returns, many hedge funds did not hedge their bets and got badly burned.

Even on the most conservative estimates, the yen's steep rally probably left carry-trading hedge funds with losses of $3.1 billion to $6.2 billion. Assuming the carry trade is as big as $1 trillion, a back of the envelope calculation suggests that hedge fund losses could reach $20 to $40 billion. With 8,500 to 9,000 hedge funds out there, it is likely that at least a handful suffered huge losses. Indeed, there is little new under the financial sun.

Comments

[Ulterior:]

The author is wrong on saying that interest rates between countries should be equal. They will never be equal, but the price of currency pair must go to point of equilibrium because of the difference in interest rates.

2008 Jun 29 03:41 AM