Yen Carry Trade.

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One of the main issues concerning the market in the recent market sell off is the Yen Carry Trade. This article is a brief description of what it is and how it could impact.

It is interesting that when the market falls, any potential negatives, previously ignored by the bull market, come into focus. The main one gaining currency is the unwinding of the Yen Carry Trade.

Part of the focus is because in terms of impact it carries by far the biggest risk to the markets, more damaging than any cycle, recession or herd. The Yen carry trade has existed since Japanese interest rates started heading down to zero after the stockmarket peak in Japan in December 1989. This is a chart of the 10 year bond rate in Japan and below it the Japanese 90 day bank bill showing the massive jump in Japanese short term interest rates in the last year.

YEN Carry Trade - What is it? Here’s a definition:

A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the interest rates - which can often be substantial, depending on the amount of leverage the investor chooses to use.

Here’s an example of a “yen carry trade”: let’s say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0.25%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change.

Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.

The potential for the Yen carry trade to unwind was highlighted by Ben Bernanke in his recent Testimony to the Senate Banking committee – Here are a couple of the slides he used.
His concerns are now becoming the market’s concerns – that the Chinese and Japanese US Bond market holdings could be unwound. If that was the case then:

• US treasuries will become less desirable, it’s a case of first out.

• The US$ would fall (and gold should go up as the global hedge against the US$)

• International funds (any fund) would try to exit any US$ denominated assets for fear of losing too much on the currency.

• Liquidity in credit markets would be squeezed.

• Stock markets would fall, led by the US (and Australia would follow).

• It could all happen very quickly.

Markets world wide are given massive amounts of liquidity by the Yen carry trade. Institutions, Banks and individuals have borrowed Yen for virtually nothing and invested it in foreign stock markets worldwide. Real estate markets have been floating on the liquidity.

The Yen carry trade finds its way into real estate markets from Shanghai to the US to Australia. Everywhere.

The Bank of Japan literally acts like the central bank of the world through the Yen carry trade, supplying liquidity that finds its way into markets everywhere. Japan’s recent interest rate rises and the re-emergence of the Japanese economy threaten to lift the Yen, reduce the value of the carry trade and reverse the trend of the US$ versus the Yen.

So the big debate now is whether the Yen carry trade is about to be unwound (or is it being unwound). The more the issue comes to the surface the more likely it is to self fulfil. There is plenty of commentary on it in the research – truth is – no one knows.

It is in almost no-one’s interest to promote this idea. If the Yen carry trade was ever going to unwind the market would, as it is, be in Denial.

But you have to suggest that despite the world playing King Canute the beginning would look something like it looks now. A sharp rise in Japanese interest rates, a sharp rise in the Yen and a sharp drop in the US$.

It is no small issue. The Chairman of the Federal Reserve has taken time out to warn Congress about it. The consequence would be pretty horrific and the fear it would create would slam into all markets. No wonder when the market corrects that fear starts to come to the surface. Its pretty much a Doomsday scenario.

Want me to call it…sorry, it is an issue that exists in the greed versus fear synapses of thousands of traders worldwide. No-one can analyse that. No one can predict it.
Interesting times.

Here is one comment from BCA Research:

So the big debate now is whether the Yen carry trade is about to be unwound (or is it being unwound). The more the issue comes to the surface the more likely it is to self fulfil. There is plenty of commentary on it in the research – truth is – no one knows.

It is in almost no-one’s interest to promote this idea. If the Yen carry trade was ever going to unwind the market would, as it is, be in Denial.




	
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