Ever since the collapse of the bubble economy, the carry trade has been an influencing factor, not only on the yen itself and the yen to dollar rate, but also in the broader economy. The sole reason the trade exists is because of the interest rate policy following the collapse of the bubble. With zero interest rates, this provides the ideal opportunity for currency speculators to profit in a wide variety of currency pairs, in particular the New Zealand dollar, the UK Pound, and the US dollar, in fact any currency pair with a substantial differential between the two interest rates. With the yen at at zero, these trades were not hard to find, and many economists blame much of the recent currency volatility, purely on the carry trade. So let us take a look and see how the carry trade works.
So what is the yen carry trade? Put simply, it is borrowing at low interest rates in yen and using the loan to buy higher yielding assets elsewhere. During the past ten years the trade has become a staple for many traders and speculators, who exploit the differential between the US and Japanese yields. For investors it has offered the opportunity to borrow in yen at a 0% interest rate, and to reinvest in US Treasuries ( government bonds) for a double pay off. Firstly, from the interest rate differential, and secondly from the dollar’s rise against the yen. Investors make their profit when they reverse the trade and pay back the yen loan. For currency traders, trading in the spot market, a carry trade is simplicity itself. All the major currencies around the world are quoted against the Japanese yen and over the years the most popular have been the USD/JPY, GBP/JPY, EUR/JPY the AUD/JPY and finally everyone’s favourite the NZD/JPY. With so many currency traders selling the Japanese yen, it is little wonder that both traders and investors have had such a dramatic effect on the currency. Indeed many analysts are concerned that once all these carry trades begin to unwind, then this will have serious and long term implications for the currencies concerned. With the recent reduction in US interest rates, the dollar to yen trade has become less attractive, with a differential of less than 2%.
Never underestimate the importance of the yen carry trade and its effect on world markets. As of early 2007 it is estimated that as much as US$1 trillion may be staked on the yen carry trade. Data from the Bank for International Settlements in Basle, Switzerland (the central bankers’ bank) indicate that the use of these structures in foreign exchange derivative transactions has risen significantly in the past couple of years. Notional outstanding values are estimated at around $40 trillion. That should be compared to average global daily turnover in the foreign exchange market of about $3 trillion, which is truly colossal. But global GDP is only about $40 trillion.
Finally there are several things to remember when trading the dollar yen or investing in yen assets. Firstly, the economy is unlike any other in the western world. It is highly dependent on its export markets which in turn are highly dependent on the strength or weakness of the yen. This in turn affects the speculation on the yen and in particular the carry trade which has been a favourite for many years due to the very low interest rates. This is likely to continue for some time to come and my own personal view is that the rates may be cut later this year back to 0.25%. Now bear in mind that a strong yen will adversely affect exports, and the interventionist Bank of Japan will ensure that this does not continue. In short, a recipe for a weak yen to dollar relationship for the foreseeable future. My personal view is that the pair will bounce back from below the psychological 100 barrier, back to somewhere between 105 and 110 in the short to medium term.
