The End of the Yen Carry Trade?

Much has been made of the prevalent role of the Yen carry trade in today's market. So let's start with a little education. What exactly is the Yen carry trade? Here's the definition via the San Francisco Fed:

In the most common version of this strategy, an investor borrows a given amount in a low-interest rate currency (the “funding” currency), converts the funds into a high-interest-rate currency (the “target” currency) and lends the resulting amount in the target currency at the higher interest rate.

In today's market the "funding" currency is often the Yen which the BOJ has kept at or near 0% for over a decade as they attempt to jump start their economy. The target currency is often the USD, as hedge funds and insurance companies have crowded into the strategy to bump up their returns. So how does the carry trade effect the markets? (from Gillian Tett at FT.com):

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

So when will the carry trade end? It certainly looks as if Japan's economy is finally growing. Though the weak first quarter numbers, 2.4% annualized, left a little to be desired the growth is solid and should be sustainable. While no rate hike is currently expected, if you read into Toshihiko Fukui's rhetoric he has left the door open to raise rates above 0.5% even if consumer prices continue to fall as long as growth continues. So don't be surprised if by the end of 2007 the Yen reverses trend in FX markets against the USD and wipes away the carry trade. Using the past as a guide, the last major period of Yen carry trade activity was from the summer of 1995 to October of 1998. In October of 1998 the Yen appreciated 18% in just three days, burning many in the process and contributing to the meltdown at Long Term Capital Management. Unfortunately exchange rate movements are notoriously difficult to predict. When the Yen does recover it is safe to say that the fluctuation could be dramatic and the unhedged will be hurt badly. For more on the Yen carry trade check out these links:

Mish's Global Economic Analysis
MarketThoughts.com
Federal Reserve Bank of San Francisco