For all the attention paid to the wobbles between hawkishness and dovishness by Ben Bernanke, Federal Reserve Board chairman, the real driving force behind world liquidity this year has been the changing policy of the Bank of Japan.

The markets’ activity at the margin has been driven by leveraged speculators rather than “real money”, as it is known in the trade. When you are looking for money to borrow, paying less than 1 per cent for short-term loans is hard to beat. What has been really important, of course, is the scale of the availability of cheap yen financing, as measured by the current account balance at the Bank of Japan.

It was the rapid withdrawal of that liquidity that led to the May decline in the prices of risk assets. When the BoJ actually raised rates this month, possibly for the only time this year, the markets found the move if anything anticlimactic.

The financial commentariat has used a lot of ink and electrons telling us about the “end of the carry trade”. The carry trade is the business of borrowing low interest rate short-term money and investing it in higher yielding instruments.

What makes it different from a mere banking business is the risk, and reward, associated with borrowing in a different currency than the investment vehicle. When you have, say, short-term yen borrowings being used to buy Hungarian forint bonds, the results on the way up and the way down can be, to put it mildly, interesting.

But hedge fund managers and banks’ proprietary traders still need to make a lot of money out of small moves in prices. So, no, the carry trade is not over. It will take much more than the May decline, which does not qualify as a crash, to end that.

But the “funding currency” for these trades is likely to change, or at least not be so concentrated in the yen. The lash of the BoJ’s whip has had its effect. What to do now?

Use the Swiss franc. This will not be a popular suggestion at the Swiss National Bank. Central bankers do not like speculators using their currencies as funding sources for carry trades because the resulting flows make it harder to direct monetary policy, especially at critical moments. Just when you need to raise rates, you, the central banker, have to consider the additional jump in your exchange rate as the hedgies cover their short positions. And it gets more complicated than that.

But the little-remarked upon Swiss franc is a well managed currency with a cheap interest rate. More to the point, in this world of more volatile currencies, it does not carry the same risk of rapid appreciation and withdrawals of liquidity as the yen.

This is not a theoretical issue. Those speculators whose experience stretches back to the dark days of the deleveraging crisis of October 1998 will recall that the Japanese minister of finance discouraged the Bank of Japan from providing liquidity to speculative yen borrowers. The results were messy. For a while, it looked as though a bankers’ crisis would turn into a recession, until Alan Greenspan went along with yet another bailout.

Right now, the market rate for yen is just 30 basis points, and the September yen futures contract implies a 50bp rate. Still cheap, yes, but you need to consider the currency risk. It does not help if you have a 5 per cent move in the currency, given the tiny spreads in many of these trades and the small equity bases. Volatility is not going away, even with occasional relief rallies.

The Japanese Ministry of Finance and the Bank of Japan share the same analysis of the Japan’s economy but they have different priorities. When there is a conflict, you can bet on the ministry winning.

The Ministry of Finance is most concerned about rises in rates because some day it will face the horror story turned reality of refinancing the world’s biggest debt burden. If the yen appreciates, that allows some tightening of monetary conditions without a rate increase, putting the evil moment off for even longer.

Furthermore, even under Henry Paulson, US Treasury secretary and a financial markets man, there will be some snarls from the US if the yen is weakened by the BoJ. So there are both domestic and international reasons for a rise in the yen, even a sharp rise, to go unrelieved by the Bank of Japan.

Now, consider the Swiss franc. The overnight repo rate is 1.45 per cent, three month libor is 1.53 per cent, and the September futures contract implies a rate of 1.78 per cent, which discounts one more rate increase. The December future is 2 per cent, which means Mr Market believes there will be yet one more rate increase. That is more than half a percentage point.

But consider the lower risk. The Swiss National Bank will never get a call from Mr Paulson insisting it not weaken the currency. Swiss exports to the US do not anger any domestic lobby. The Swiss government does not have an outsized debt burden, which would be hard to refinance at affordable rates. In other words, there are not the policy constraints there are in Japan. Finally, the Swiss economy, while better, is not so hot that the SNB would be indifferent to a rising currency.

“It’s not like Japan,” as one monetary economist says. “There won’t be any 5 per cent short-term moves in the currency. If you need to cover a position by buying francs, the SNB will likely accommodate your requirements.”

There are other potential funding vehicles, of course, but ones with lower rates and less currency risk than the Swiss franc are hard to find.

Goldbugs insist there is a big gold carry trade that threatens the world financial markets. The idea is that traders have borrowed gold, which does have low rates in the interbank market, and used it to buy high yielding but risky assets.

I have looked at that several times over the years. The problem is that gold is too volatile and does not correlate well with other assets, meaning there is too much obvious risk to make it an attractive trade. The exception would have been borrowing gold to buy high yielding South African rand instruments. Even in that case there is not a liquidity provider for gold, like a central bank, to supply needy borrowers.

So keep your interest costs and risks down, even if it does annoy the SNB. Go for the Swiss carry trade.

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