Investors caught up in the gyrations of currency markets cannot say they were not warned. For months pundits have signalled the possible unwinding of carry trades – where money borrowed in currencies with low interest rates is invested in those offering higher ones. Does the jump in the yen over the past week mark the end for the carry trade?
As expected, positions have reversed with a snap. In the past five days, the yen has leapt 7 per cent against the South African rand and 5 per cent versus the Australian dollar, two popular carry trade currencies. Last Tuesday, trades on electronic brokerage systems totalled $266bn – double the average daily value.
For now at least, these moves are technical rather than fundamental. Short-term currency traders are buying yen on momentum. Even those following longer-term currency models are forced buyers, as stop-loss programmes automatically close-out positions when losses reach a certain level. International Monetary Market futures data for the end of February showed the smallest increase in yen net long positions for nine months, a sign that the carry trade may be running out of steam.
Although Japanese retail punters have been selling the yen into strength, new carry trades are on hold until the dust settles. Investors are worried that the focus might be shifting from the carry trade to fundamentals. At 20-year lows on a trade-weighted basis, the yen is undervalued and Japanese interest rates may rise further if the economy picks up. On the other hand, the New Zealand and Australian dollars are overvalued and growth expectations are moderating.
Carry trade bulls draw parallels with the second quarter of last year, when the currency market ultimately took a similar wobble in its stride. However, this time round things may be different: it is clearly now possible that the Federal Reserve might shift to a loosening rather than tightening bias, just as Japan begins to normalise its interest rates. If currencies have any relationship to fundamentals, that scenario would spell the end of the carry trade.
