Friday, 3 August 2007

Yen to gain as leverage dominoes fall

This is a great article on the structure of the Yen carry trades:

London, August 2 (Reuters) - The great repricing of risk now happening in global markets will undermine the lure of the yen carry trade, supporting the Japanese currency and hitting higher yielders like the New Zealand dollar.

It will take months at a minimum for the near panic now gripping credit markets from mortgages to leveraged loans to be resolved, and it's likely that more shocks will emerge. This means volatility in markets stays high, the appetite for risk is suppressed and everything that involves borrowing money is, on the margin, less attractive.

The carry trade, variously estimated at between $20 billion and $1 trillion, is perhaps the world's biggest bet. It is narrowly defined as borrowing cheaply in yen and buying investments in other currencies that pay a higher rate of interest. But many investors also fund in yen to make bets in any number of markets that they think will go up. The trade, popular with hedge funds which often borrow many times the capital they commit, is sweetness itself, so long as the yen doesn't appreciate.

Official rates in New Zealand, a popular play for carry traders, are at 8.25 percent, against a 0.50 percent overnight rate in Japan, while Iceland boasts a 13.3 percent nominal discounted rate. But, like so many other leveraged bets now coming unstuck, it can be very painful if markets move the wrong way. Thus far the yen has appreciated 3.8 percent on a trade weighted basis during recent tensions, according to Barclays Capital. That will have piled pressure on investors holding leveraged yen short positions.

The New Zealand dollar has been hit, plunging more than seven percent against the yen since July 24. During this period, yen strength has been highly correlated with stock market weakness. Volatility in yen has risen along with other measures, such as the Chicago Board Options Exchanges' Volatility Index <.VIX>, the so-called "fear gauge." "The (yen) needs to be watched closely at this juncture for if its steady appreciation starts to accelerate the walls could come tumbling down on the carry trade and that could make the recent market panic look like a picnic," Bear Stearns currency strategist Steve Barrow wrote in a Wednesday note to clients.

But while hedge funds, which may be exposed to other volatile markets, may be quick to rein in carry trade bets, it is an open question if increasingly influential Japanese retail investors will. Japanese salarymen and housewives, not satisfied with puny local interest rates, have been big buyers of high-yielding debt in other currencies, often trading from computers at home or using mobile phones. While the size of this market is hard to measure, some estimates show it accounting for a quarter of all spot foreign exchange trading during Tokyo hours.

These small fry are less aware of global trends and may only capitulate after a long and grinding rise in the yen, rather than because of the latest hedge fund collapse or prime mortgage default. At issue too, is the Bank of Japan, which is expected to raise interest rates to 0.75 percent in late August in a move which would eat into the interest rate differential carry trades exploit. While even a small decrease in the carry trade could have a big market impact, some very bearish analysts are expecting more.

Tim Lee, of piEconomics in Stamford, Connecticut, sees an imminent unwinding of the carry trade. "Over the last few years we have been experiencing an enormous credit bubble that has been based on a willingness to ignore risk, both credit risk and exchange rate risk," he said in an email interview. "Necessarily therefore credit has been drawn in the low interest rate currencies and funds have been placed in the high interest rate currencies. The whole bubble is now beginning to collapse, and the process of collapse cannot be reversed."
By James Saft, a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own direct investments in any securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

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