As suggested in earlier carry trade reports, the unwind of carry trades would ripple from one cross rate to the next. The initial unwinds in July/August were most severe in the Aussie/Yen and NZ/Yen carry trades. For the most part, carry trade investors have put those trades back on.
In the meantime, since the Fed cut the discount rate in mid-August, investors have begun taking off their DX/JY carry trades, a trend which has continued to accelerate as the US financial sector slips into a full blown recession. Cyclically, the DX/JY carry trade unwind should continue as long as the BOJ and Federal Reserves short term rates are converging. This convergence could take years as we have no idea how long the Fed will continue to cut rates, pause, and then begin to hike rates again as the economy pulls out of its sluggish recessionary tendencies.
The chart above shows the Dollar/Yen unwind accelerating after the Federal Reserve cut the Discount Rate on August 17 2007. If we look at the daily Yen chart as a stand alone, we can see a few more details that speak to carry trade investors risk averse behavior towards owning US dollars. Carry trade investors risk averse behavior began in June after two Bear Stearns Hedge funds blew up, and that aversion continued until the Fed cut the discount rate on August 17th. Believing the Fed’s accommodation would calm the markets and solve the liquidity crisis in the credit markets, fears abated, and the Yen retreated. The Yen retreated that is until investors realized that Fed rate cuts were not going to be the panacea they had hoped for the credit markets and financial sector.
When financials began reporting Q3 earnings in mid-October, it soon became evident that those credit problems were not going away simply with a wave of the Fed wand. The Fed’s magical wand simply cannot stimulate markets that are not transparent and that priced at "Mark to Make Believe." Discovering the Fed’s wand was merely "pushing on a string" in mid-October, carry trade investor behavior’s became even more risk averse – as we now see the Yen still trending higher since Bear Stearns blew up, and the Financial Sector fell into a full blown earnings recession that should persist at least through the 1st half of 2008.
