Japanese Economy: Carry Trade Becoming Dangerous

Tokyo, 30 Oct. Will the impending economic slowdown spell an end to the Japanese carry

Tokyo, 30 Oct. Will the impending economic slowdown spell an end to the Japanese carry trade?

Ever since Japan has had rock-bottom interest rates, the carry trade has been popular with the yen, with the lowest interest rate among industrialized countries. Arbitrageurs and traders have exploited the difference between the Bank of Japan lending rates – previously at 0% – or half a percent more recently, and the lending rates of other central banks around the world. It has been described as “3-3-3”: Buy at 3%, sell at a 3% profit, and be on the golf course by 3pm.

Emerging market equities have been popular targets for these funds, as have more mainstream equities and commodities, and most often, high-paying, predictable, US dollar bonds. The Australian dollar has also often been used due to the wide interest rate spread between the two central banks (often up to 5.5%). Although carry trade profits are not always massive, they can be consistent and long-term.

Now, however, the carry trade with the yen is becoming more and more risky due to the overvalued yen. Currency risk has always been inherent in the carry trade, but recently the yen has appreciated and this has wiped out gains for many, cycling the money back into the yen to pay back the trading loans.

For example, this recently occurred in the Australian dollar versus the yen in September and October amid the financial crisis. A huge drop then meant that any Australian carry trade profits – even over the prolonged period the currency was strong relative to the yen – were obliterated.

Of course, the upside is that this kind of low price point could be seen as an entry opportunity, close to historical lows. And given the wide gap between the two countries’ interest rates, there is some still buffer room for comfort.

But still, with the yen getting so strong, (it is at a 13-year high against the US dollar) the Bank of Japan has intentions of cutting its already dirt-cheap interest rate. Currently at half a percent it does not have much more room to go. But as it stands, Japanese exports are overpriced, and this is the last thing the world needs as it heads into recession.

The rate might drop to a quarter of a percent, and may soon even creep back to zero. The Bank of Japan must be terrified of another rate cut but with the Nikkei struggling at a 26-year low and an overvalued yet, not doing so may be even more terrifying.

No cut could cause a return to bubbles in the carry trade, capital investment and real estate, along with decreased exports.

Hiromichi Shirakawa, a senior Credit Suisse economist in Tokyo wrote, “As the financial market turmoil continues, the BOJ looks to be prepared for additional easing actions. We do not rule out the possibility that the zero interest rate policy could be introduced by the BOJ next year, but we will have a better idea of the likelihood of this after reading the [accompanying] statement Friday.”

Much of the appreciation of the yen is due to unwinding of yen carry trades. Sharikawa added, “We tend to believe that a small rate cut would do little to change currency market trends on a sustained basis. Unwinding yen-carry trade positions and the substantial decline in household risk appetite that limits capital outflows appear to matter more.”

In early 2007, the Bank of Japan limited money supply, causing the yen to rise against the US dollar, and many carry traders sold their assets to pay back their yen commitments. In fact, this is what could be happening now, and this carry trade money further strengthens the yen as it goes back to Japan. Reuters, Forbes, and Bloomberg all reported ominous news for carry traders. The next day, the yen weakened and they reported the opposite thing: The carry trade is back.

However, with recessionary scares ahead, we may have more trouble than in the past. According to strategist Albert Edwards, of Dresdner Kleinwort, much of the carry trade funds go into high-risk cyclical assets, which fall in value during a slowdown. The result? Traders bailing out just as they would with a rise in the yen.

Hiroko Mirafiori, EconomyWatch.com