US Subprime Concerns Help Stir Yen Rally

Today’s post is a bit of a public service, as most techies will have little awareness (justifiably) about the “Yen carry trade”. But this short research summary from the RBC Capital Markets research teams (in both Toronto and Sydney) is a great primer. It reminds all of us how little we, as individuals, truly know about the global capital flows; but it is also further proof about the ability of a credit shock in one part of the market to weigh down on another.

Gold Price Impacted by Yen Carry-Trade

Over a 2-week period in late February/early March 2007, the US dollar and the gold price weakened simultaneously, in contrast to their historically strong negative (inverse) correlation. We explained this unusual relationship in our report entitled Global Gold Outlook: A Pause – Then Re-Test $725/oz Before Year-end - (March 30th 2007), and highlighted the adverse impact that the unwinding of yen carry trades appears to have on the price of gold.

Speculative investors, motivated by interest rate differentials between Japan (with low rates) and other countries, look to profit by shorting the yen, on the belief that interest rate differentials are a key driver of currency values. Yen appreciation currencies such as the USD can trigger the need for these speculators to cover their short positions, in turn requiring that yen-denominated investments be sold, which is commonly done through the sale of yen-denominated Nikkei futures, or gold futures on the Tokyo Commodity Exchange [TOCOM]. This margin covering results in downward pressure on gold and the Nikkei.

In the opposite scenario, when the yen depreciates versus other currencies, a corresponding rise in the gold price and Nikkei can occur, as carry-trade investors redeploy margin to increase existing long Nikkei and gold futures positions.

Concern over U.S. sub-prime rates and stronger-than-expected Japanese retail sales have led to yen strengthening (USD weakening) and reduced yen carry trade activity. This week, the yen (in USD terms) has appreciated from 123.9 to 122.8, while gold has declined from $654/oz to 643/oz.

As a result of our thesis regarding this interaction between the yen, USD gold price and Nikkei, it comes as no surprise to us that price movements between the three instruments show strong correlation.

Implications.

Although yen carry-trade activity is just one of countless influences on money flows into and out of the gold market, the dynamics associated with it appear to have a significant impact on the recent decline in the gold price. Continued yen strength over the next several weeks would lend further support to our thesis that gold will drift lower early this summer, to a range of $625 to $635/oz, before strengthening due to fundamental seasonal gold demand in the late summer/early fall period.

Got that? U.S. subprime concerns help stir a rally in the Japanese Yen. Temporarily driving down the price of gold. Who knew that Bear Stearns (BSC) was so influential as to impact one of the largest economies in the world?