The yen sold off sharply on Wednesday as a co-ordinated injection of liquidity from the world’s major central banks eased concerns over the health of the global financial system and supported equities.
In the foreign exchange market, the resulting rise in risk appetite translated into increased demand for carry trades, in which low-yielding currencies such as the yen are sold to finance the purchase of riskier, higher-yielding assets elsewhere.
The yen fell 1.5 per cent to Y112.29 against the dollar on Wednesday, dropped 1.9 per cent to Y165.07 against the euro and 2 per cent to Y230.00 against the pound.
The Japanese currency dropped further against higher-yielding currencies, tumbling 2.3 per cent to Y99.43 against the Australian dollar and 3.3 per cent to Y89.00 against the New Zealand dollar.
“To see concerted central bank action to relieve liquidity problems certainly has a ‘wow’ factor and the yen’s fall as the pressure eases on risky assets certainly makes sense,” says Paul Mackel, currency strategist at HSBC.
“The key to the yen sustaining its losses lies in whether this represents the nail in the coffin for recent liquidity problems. If they persist, yen weakness is unlikely to last.”
Worries over the financial sector saw investors abandon carry trade strategies in November. Over the month, the yen rallied strongly, rising 3.8 per cent against the dollar, 2.7 per cent against the euro and 5.4 per cent against the pound.
However, even before Wednesday’s liquidity injection, the yen’s rally had stalled as it failed to build on November’s gains in the early weeks of this month. Simon Smollet at Calyon says there were signs that conditions for carry trades were improving, with the cost of insuring against a sharp rise in the yen in the options market falling sharply to its lowest level since the start of November.
“A lot of bad US news is already priced into the financial markets, which should ensure that risk aversion does not rise into the year end,” he says.
Indeed, analysts say that the yen’s failure to build on November’s gains coincided with increasing activity from the sovereign wealth funds of cash-rich Asian and Middle Eastern countries. They have not only ridden to the rescue of some of the world’s leading financial institutions, but have also helped the global carry trade.
Ordinarily, a massive writedown at a Swiss bank would not encourage risk taking on the foreign exchange markets.
However, analysts say the fact that UBS attracted a capital injection to cover its $10bn loss from the Government of Singapore Investment Corporation earlier this week helped stabilise confidence in the financial markets and boost risk appetite.
Sovereign wealth funds have moved away from their traditional investment in low-yielding bonds towards equities.
In particular, they have been taking stakes in financial institutions suffering the fallout from the crisis in the US subprime mortgage market.
The recent financial crisis has been instrumental in triggering this activity, allowing sovereign wealth funds to overcome protectionist barriers. Without the crisis, the barriers would still have been there and it would have been harder for the funds to take the stakes, analysts say.
“Sovereign wealth funds are moving into the carry trade by selling low-yielding bond holdings for equities,” says Hans Redeker at BNP Paribas.
“We have changed our trading strategy on the back of this.”
Foreign assets of oil-producing countries are estimated at between $3,400bn and $3,800bn, while Asian central banks administer $3,200bn.
“Meanwhile, total losses in the global financial sector as a result of the collapse of the US subprime mortgage market have been estimated at between $300bn to $450bn,” says Mr Redeker.
“This is less than 10 per cent of what sovereign wealth funds have under their wings.”
He says the fact that sovereign wealth funds stand ready to invest in distressed assets and western companies should keep equity markets supported.
“We no longer trade against risk, but with risk, abandoning bearish carry trade strategies for now,” says Mr Redeker.
However, Derek Halpenny at Bank of Tokyo Mitsubishi says even though the yen may weaken in the short term, declining risk appetite among Japanese investors is likely to keep the currency’s losses in check.
He says the prospect of risk aversion continuing among Japanese investors was highlighted early this week by terrible Japanese consumer confidence data, which fell to its lowest level for four years.
Before the start of the recent credit crisis, Japanese retail investors were leading investors in the global carry trade, selling the yen to take advantage of higher yields on offer outside of Japan.
However, this yield advantage was quickly wiped out by currency movements as the yen appreciated, forcing Japanese retail investors to cut back their bets against the currency.
According to Mr Hal-penny, Japanese retail investors’ bets against the yen have this week fallen to their lowest level since the start of November.
Indeed, he says, since last Wednesday, when the yen began to fall against the dollar, Japanese retail investors have cut those bets by nearly 10 per cent, underlining their eagerness to lock in profits on any move lower in the yen.
“We maintain that this period of yen weakness will not last, given the less-than- favourable conditions for a sustained build-up of carry positions,” he says.
“The lack of risk appetite amongst Japanese market participants remains apparent.”
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