After the sharp global sell off in stocks that occured on February 27th, it has become apparent to me that the low volatility seen in the markets will not last. This poses a serious threat to anyone who has a position in the Yen carry trade, which can be seen in the Yen's appreciation during Tuesday's sell off in the equities markets. In many ways, the carry trade is a classic case of reflexivity, where one's actions influence valuation and events that do not reflect reality.
Summary: The Yen is currently undervalued, and should appreciate relative to other currencies. Nevertheless, speculators continue to implement a Yen carry trade, artificially pushing down the value of the Yen in the near term, and earning a profit on the spread between Japanese interest rates which are at .5%, and interest rates in other markets such as the United States, which are currently at 5.25%. This is a distortion of fundamental reality, and eventually markets will reflect the true value of the Yen sooner or later.
Background: Japan experienced strong deflationary pressures following the collapse of its asset market bubble that lasted from 1986-1990. During this period, the land around the palace in Tokyo was worth more than all the real estate in California at the time. Japan’s economy recovered during the 1990’s, and saw a growth of +50% in the Nikkei in 2006.
Discussion: In the February 10th issue of The Economist, the article Carry on Living Dangerously was written to point out what the implications of an undervalued yen may have on the global economy if the yen appreciates. For this reason, the article argues that the popular yen carry trade, whereby one sells the yen and converts it into a higher yielding currency, put on by many hedge funds, proprietary traders and speculators around the world may end badly, as traders are forced to unwind their positions. Furthermore, as more and more participants enter into this trade, the greater the risks become to the global economy. The yen’s valuation, traders, market fundamentals, the Bank of Japan, and the Japanese economy will ultimately determine how this carry trade will play out in the coming months. I put forth the following arguments:
(a) Valuation: The yen is arguably one of the most undervalued currencies in the world, and in theory should appreciate relative to other currencies. After recovering from the 1980’s Japanese asset pricing bubble for much of the 1990’s, Japan’s economy has slowly recovered by implementing an extremely low interest rate policy. This has created some unintended consequences, including a depreciation of the yen and large positions in yen carry trades that have caused the yen to become undervalued. The most compelling argument for an undervalued yen is that Japan has “one of the world’s largest current-account surpluses and low inflation,” signaling that it should have a much stronger currency (The Economist). The Japanese current account surplus by 2005 estimates is approximately $165.6 billion (www.cia.gov). Even more, according to The Economist’s Big Mac index, “the Yen is a massive 40% undervalued against the euro,” and “America’s big carmakers have complained that the weak yen makes imported Japanese cars unfairly cheap” (The Economist). European policy makers share the sentiment of the Big Mac index and feel that the yen needs to appreciate because “it is not bearing its fair share of the dollar’s decline” (The Economist). Additionally, the beginning of February 2007 saw the yen hit an all-time low against the Euro and a trade-weighted value that is at its lowest since 1970. Currently, 1 Euro is worth about 160 Yen and 1 US Dollar is worth 120 Yen.
(b) A crowded trade: Traders at hedge funds, banks, as well as locals on exchanges continue to pile into large positions in the Yen carry trade. As a result, the yen continues to depreciate as more and more speculators enter into the yen carry trade, “amplifying the distortion” (The Economist). Importantly, large institutional traders have generally taken positions in the Yen carry trade through derivative positions, especially in forward currency swaps that hedge funds favor because they are a form of off balance sheet financing that helps them to conceal their positions from other traders. Furthermore, Chicago Mercantile Exchange data estimates short positions in yen futures total approximately $1 trillion. This is a massive short position even by currency market standards.
(c) Catalysts: Eventually the yen carry trade will unwind itself as markets, over long periods of time, correct inefficiencies. Nevertheless, a catalyst will be needed to cause the Yen to appreciate, and will likely come in the form of policy intervention by the Bank of Japan or an increase in market volatility. The Bank of Japan can intervene by raising interest rates or by selling foreign currency reserves, either of which will cause the Yen to appreciate. The other situation that would cause the Yen to appreciate is an increase in volatility, which has been historically low over the past few years across a broad range of asset classes that includes currency. Traders will be forced to close out their positions by buying Yen, causing the Yen to appreciate sharply, in a similar fashion to what happened to the Yen in 1998 when Russia defaulted and Long Term Capital Management, a relative value hedge fund, was forced to unwind their positions in Russian credit spreads, which caused the Yen to sky rocket by 20% in 2 months. Worsening things, in a situation of high volatility, uncorrelated markets will become correlated due to a lack of liquidity caused by force selling. This will further serve to increase the rate that the Yen appreciates as traders seek to close out the carry trade here to raise cash in a panic to meet margin calls in other positions and allocate funds into safer investments.
(d) Counter Arguments: In the near term there is a strong possibility that the Yen carry trade will continue to be successful for reasons that concern the local Japanese economy, policy decisions at the Bank of Japan, and large speculator’s ability to withstand short term fluctuations in volatility. First, many Japanese tourists travel abroad every year, exchanging yen for foreign currencies. Second, Japanese individual and institutional investors are desperately searching for yield and consequently have allocated their money into foreign assets, which has put more downward pressure on the yen. In fact, many Japanese households have taken their money out of Japanese banks and put them into New Zealand bonds to generate better returns (The Economist). Third, even with the rate hike from .25% to .5% by the Bank of Japan that occurred on Wednesday, February 21st, the interest rate differential between Japan and the United States is still substantial. Interest rates in Japan are currently .5%, while interest rates in the United States are 5.25%. Fourth, incoming foreign direct investment remains significantly lower than out-flowing non-portfolio capital. Policy makers in Japan likely feel that the Japanese economy has suffered for too long and see a weak yen as beneficial to the Japanese economy. Finally, large traders, which include hedge funds and banks, will be able to withstand short term volatility because of their deep pockets, and will not be taken out of their positions easily, not withstanding a major increase in volatility.
Recommendation: The yen carry trade poses serious risks to the global economy. As the yen is fundamentally undervalued, over time it should appreciate to its appropriate level. Nevertheless, in the near term, traders will continue implementing yen carry trades as it has been a very profitable strategy, and will probably remain profitable for the next several months.
As a result of the trade’s success, positions will get larger and become more leveraged as traders seek to chase returns, depreciating the yen through a self-reinforcing bias, and increasing risk to global markets. The Bank of Japan should raise interest rates sooner rather than later to force speculators out of their positions before their yen carry positions become so large that they are illiquid and threaten global economic solvency. For these reasons, I believe going long the Yen is a profitable trading strategy.
Disclosure: The author is long Japanese Yen