Here’s the by line from the article in Barron’s: “Could a Japanese debt crisis help spur a rally? Perhaps, if it fuels the yen carry trade.”
But rather than precipitating a panic, a decline in the overvalued yen would serve as a tonic in two ways.
The most obvious would be to give a lift to Japanese exporters, which have been hampered by the yen’s strength, not only against the dollar but even more so against other currencies. Remember, the greenback has appreciated markedly in the past four months against a basket of currencies, as represented by the U.S. Dollar Index.
Meanwhile, the yen has more than kept pace, which has two important implications. Relative to other major currencies such as the euro, the yen has gained even more. And relative to the Chinese renminbi, which effectively is pegged to the dollar, the yen has also risen, reducing Japan’s competitiveness versus that export colossus.
The effects of an lower yen were readily apparent Monday when the Nikkei stock average soared 2%, as the dollar firmed in reaction to Friday’s news of a smaller-than-expected dip in U.S. payrolls in February. But the positive momentum faded early Tuesday in Tokyo as the yen steadied.
The impact of a weaker yen would be felt worldwide if it spurs a renewal of so-called carry trade. That would involve using yen to fund purchases of other, higher-yielding securities. In its simplest form, a yen-carry trade might involve borrowing yen, costing practically nothing, to buy Australian bonds yielding 4%.
Then yen-carry pays the spread between the two interest rates. With the magic of leverage, that nearly four-point spread can be multiplied many times. Borrow, buy; repeat, to paraphrase the shampoo instructions.
The risk isn’t the usual one with leverage — a rise in borrowing costs. The Bank of Japan isn’t moving away from its zero-interest-rate policy any time soon; in fact, it is looking for additional means to ease monetary policy. The risk of the carry trade is exchange rates. But when the yen rises, the cost of that borrowing increases because the yen-carry trade is effectively a short sale of the currency.
That was readily apparent during the markets’ meltdown in late 2009 and 2010, when the dollar and the yen soared, partially because of a scramble for the safe haven of these currencies. But less apparent was the demand for dollars and yen to unwind carry trades — to cover those shorts. It was the mother of all margin calls.
Perhaps the best gauge of global markets’ risk appetite is the euro-yen exchange rate. When that appetite is robust, the euro tends to be strong and the yen is weak, and vice versa. So, as the Greek crisis built, the euro-yen rate went from about 133 yen to the euro in January to around 121 yen per euro, before backing off Monday to 123. When markets were in rally mode last summer, euro/yen traded as high as 138.
The ideal funding currency for a carry trade is one that is likely to get cheaper. One thing that ought to weigh on the yen is Japan’s parlous fiscal situation, which has gained increasing attention since Barron’s Jon Laing gave it the attention it deserved nearly six months ago (“Is the Sun Setting on Japan,” Sept. 28.)
For the full article, click here.
For readers of our letter, shorting the yen is not a new theme. In my opinion it is a fat pitch, with the main source of risk being timing rather than direction, so maintaining appropriate leverage is key. The secondary question is what people will do with the currencies that they purchase. For example, if you short the yen and buy dollars, where will those dollars flow? Treasuries? With mini-yields, they don’t really offer a good trade-off. Aussie bonds? Perhaps. I’m sure some fund managers miss the days of being able to buy some Icelandic offerings – but those funds are probably gone anyway.
The answer is that there could be a global carry trade, much bigger than the one described in the article, whereby dollars and yen and euro are used to fund risk trades. That trade is an inflation trade in another form – everyone wants to get rid of their cash and put it into assets (physical or financial). It’s not a long equity play at all, but rather a short currency play that is being manifested in the markets. It would explain 17% U-6 unemployment, with awful demographics across Europe and Japan (especially), and a tapped out US consumer, with increased financial and physical assets.
There is another option…which is just that the markets are pricing in a recovery ahead of better numbers up ahead.
General, Quant, Strategy/Allocation | Yaron Sadan | 
March 9, 2010 11:54 pm | 
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