Pressure grows on yen carry trades

The yen carry trade is in trouble again.

On Monday, the Japanese currency rose through Y110 against the dollar for the first time in 18 months, and climbed 2 per cent against the euro, 2.4 per cent against sterling and an eye-watering 4.4 per cent against the Australian dollar.

There have been a number of yen rallies since the start of the credit crisis in August, leading to speculation that the once profitable carry trade might soon be abandoned. But each time, the sell-offs have merely given investors a better entry point into the trade. This time things might be different, say analysts.

The success of a given carry trade requires two elements: a funding currency with a low yield, such as the yen, and stability in asset markets. At its simplest, investors fund investment in higher-yielding assets by borrowing in the low-yielding yen. This strategy works well when the yen is depreciating or stable, but any sharp upward move in the yen or downward move in asset prices can quickly wipe out any yield advantage.

Clearly, low Japanese yields are still in place. However, it is the asset side of the equation that has been called into question amid increasing worries over the health of the financial sector. Benedikt Germanier at UBS says the bank’s FX Risk index suggests the market is once again close to fear levels last seen in mid-August at the start of the recent turmoil.

“Financial stocks in the US and Europe have weakened substantially,” he says. “Spillover into other sectors and ultimately into the real economy is looming. This doesn’t bode well for carry trades, which typically perform in an environment of stable or rising growth expectations and low market volatility.”

Mr Germanier says the UBS Risk Index has remained in risk averse territory since the end of July, but has started to spike higher since November 5, signalling that participants are about to take risky bets off the table.

Earlier this year, the popularity of the carry trade strategy sent the yen to multi-year lows against higher-yielding currencies. But the carry trade suffered a setback in August, with a typical basket of high-yielding currencies against the yen losing 20 per cent of its value, wiping out all the gains for the year.

It recovered from this setback in September and October, with the euro, sterling and Australian dollar almost retesting their previous highs. It seemed investors were reluctant to give up on a strategy that had been successful for so long.

However, Hans Redeker at BNP Paribas believes things will be different this time.

He says that with the carry trade coming under sustained downward pressure at this time of year, there is an increasing likelihood that it will deliver a negative return for 2007, the first annual loss since 2001 for the strategy.

“The FX carry trade is now facing its most severe threat for many years,” says Mr Redeker. “The current position unwinding has the potential to extend well beyond that witnessed in August, suggesting high-yielding currencies are now at risk of a sustained sell-off while low-yielding currencies, particularly the yen, are starting a major rebound.”

At its weakest, the yen stood at Y107.40 against the Australian dollar and Y168.80 against the euro in July, and Y123.86 against the dollar in June. It has since risen to Y98.05 against the Australian dollar, Y161.14 against the euro and Y110.30 against the US dollar.

One of the most striking features of the recent price action has been the close correlation of the low-yielding yen and Swiss franc to global stock markets, with both currencies selling off as stocks rise and rising as stocks dip.

Mr Redeker says this tight relationship makes him “ultra-cautious” on equity markets, notwithstanding the fact that a weakening financial sector already suggests broader declines in global equity indices.

He says Japanese and Swiss investors are the biggest holders of foreign-
currency-denominated assets and that in times of rising risk appetite they do not typically hedge their currency exposure.

However, he says rising risk aversion will prompt those investors to rush
to buy the yen and Swiss franc to cover their currency exposure.

“The correlation of the yen and Swiss franc with equities suggests equity markets are likely to sell off within this environment.”

The potential for a sharp appreciation in the yen has the Japanese authorities worried, given its potential to knock any recovery in the Japanese economy off course.

Indeed, Yasuo Fukuda, the Japanese prime minister, warned this week that the yen was appreciating too fast and cautioned traders not to make speculative moves on the currency, saying they should be careful to avoid intervention from the Japanese government.

However, David Woo at Barclays Capital says that while there is little doubt that the Japanese authorities do not welcome speculative and volatile currency moves, they are unlikely to intervene to halt yen appreciation in the near future.

“This is because such intervention would be at odds with the G7’s pressure on China to allow faster renminbi appreciation,” he says. “More importantly, we think that the government is now tolerant on medium and long-term yen appreciation.”

Mr Woo says there is currently a more balanced view on the merits and demerits of yen strength among Japanese policy makers and corporate executives, which is very different from the broad-based aversion to yen appreciation that existed a few years ago.

“The implication is that the Japanese authorities are unlikely to halt yen appreciation by intervention, although they may use verbal intervention to stop sharp and speculative moves,” he says.

Additional reporting by Andrew Wood in Hong Kong and Jonathan Soble in Tokyo