1. The Magazine
  2. April 2006
  3. Corporate Finance : Shift in Japan’s monetary policy threatens to reduce the appeal of lucrative yen “Carry trade”

Corporate Finance : Shift in Japan’s monetary policy threatens to reduce the appeal of lucrative yen “Carry trade”

Author: Gordon Platt

Foreign exchange

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The logic couldn’t be simpler. An investor borrows Japanese yen at a low interest rate and invests the proceeds in US treasury bonds or higher-yielding emerging market bonds. The interest-rate differential provides an easy route to arbitrage yield gains. This so-called “carry trade” has been very popular with hedge funds and other global investors in recent years, but the gravy train could be nearing the end of the line.

The Bank of Japan voted last month to end its quantitative easing policy, preparing the way for an eventual increase in interest rates. This means that the yen carry trade will become less attractive and more risky, since the Japanese currency might rise, analysts say. A rising yen would make it more expensive to pay back these loans at the same time that the yield differential, or potential profit, would narrow if Japanese rates rise.

The massive unwinding of the yen carry trade could prove to be the most significant development in the foreign exchange market in the first half of this year, says Dennis Gartman, editor and publisher of the Gartman Letter, a Virginia-based investment advisory service. “We must remember that the market has been layering on the yen carry trade for the past several years,” he says. “It has helped to finance speculation in gold, base metals, grain, oil, stocks in North America, Europe and Asia.” According to Gartman, “The unwinding of such enormous positions shall either be done slowly and over a great deal of time and likely in tears, or it shall be done swiftly, massively and accompanied not only by tears, but also by a great deal of pain.”

Analysts say the Bank of Japan is aware of the size of the carry trade, however, and will move very cautiously in shifting monetary policy in order to minimize the potentially destabilizing effect of a reversal in capital flows on global financial and asset markets, as well as to make sure that its tightening doesn’t snuff out the nascent Japanese economic recovery.

Global Glut in Funds
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some introduction here

“I would imagine that the adjustment in the markets will be a longer-term proc ess, rather than a crisis,” says Robbert Van Batenburg, head of global research at Louis Capital Markets, a New York-based broker-dealer of equities and derivatives. “There is still a lot of easy money around,” he says.
There is a global glut in investment capital and an increased appetite for risk, as reflected in narrow spreads of corporate bonds to US treasury securities and of emerging market debt to treasuries, Van Batenburg says. “Emerging markets are benefiting from global growth, and money is flowing into raw materials, gold, natural gas and other resources because the real economy is growing so fast,” he says.
If the yen-carry trade is unwound, hedge funds could re-deploy these funds in the equity markets, benefiting stock prices, according to Van Batenburg. And if the US yield curve were to get steeper as the result of Japanese or Chinese investors withdrawing funds from the bond market, which could force up yields, this could benefit US banks, which have been hurt by the flat yield curve, he says.
“I think there is a very low likelihood of a scenario in which there would be blood in the streets,” Van Batenburg says, “but an event in the past of similar magnitude is hard to imagine. It could have a similar effect to revaluation of the Chinese yuan.” The Japanese and Chinese central banks have accumulated $1.6 trillion in foreign exchange reserves, and normally the dollar would have declined as a result, he says. Instead, Japan and China have kept their currencies undervalued, he notes. Now hedge funds and other investors will need to purchase yen to unwind their carry trades. If the yen were to rise too quickly, the Bank of Japan would intervene at the behest of the Japanese Ministry of Finance to buy dollars and restrain the yen’s rise, he says.
“The yen carry trade is not done yet,” says Brian Dolan, director of research at GAIN Capital, Bedminster, New Jersey-based provider of foreign exchange services, including direct-access trading and asset management. “The Bank of Japan and the Ministry of Finance, which calls the shots on the currency, will disappoint those looking for yen appreciation,” he says. “The yield differential of the yen with the dollar and the euro will continue to widen as the United States and Europe raise rates, and the yield pickup is going to continue.”
There will be a plateau period once US rates reach a peak, but the carry trade could continue for the rest of 2006, Dolan says. The Bank of Japan is unlikely to raise interest rates until the fourth quarter of this year or the first quarter of 2007, he says.

Krona Crumbles
The Icelandic krona, one currency that had benefited from carry-trade investments because of the country’s high interest rates, fell 9% in two days in February, following a negative outlook from Fitch Ratings. Fitch revised the outlooks on Iceland’s foreign and local currency issuer default ratings to negative from stable.

The rating agency said Iceland’s banks have become heavily dependent on foreign funding and could ill afford to be shut out of international capital markets for any length of time. The country’s current account deficit expanded to 15% of gross domestic product in 2005, and foreign debt rose sharply, Fitch noted.

Analysts say that currencies of countries that have benefited from the carry trade could be vulnerable to speculative reversals of foreign capital flows, and that the unwinding of these trades could trigger instability if big investors decide to exit all at once.

Meanwhile, hedge funds that have invested heavily in carry trades could find high returns more difficult to attain. “Just as a positively sloped yield curve turned many bankers from idiots into financial geniuses as the earnings from borrowing short and lending long overcame bad lending decisions, so too has the carry trade covered the sins and losses of the hedge fund universe for a very long while,” says Gartman of the Gartman Letter.

The yen has been borrowed in enormous size over the past several years, with the proceeds used to make investments almost anywhere else in the world, Gartman says. In the case of Iceland, the trade worked so well that not only did hedge funds earn the difference between the interest rate at which they had borrowed and the higher rate at which they had lent, but the Icelandic krona rose as a result of their relentless buying and the yen fell, he says.
It was the best of all worlds, Gartman says, until Toshihiko Fukui, governor of the Bank of Japan, suggested in late February that interest rates in Japan were likely to rise. This forced months of krona-buying to be reversed in a day or two, according to Gartman.

Global Glut in Funds
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The carry trade worked as long as the yen did not appreciate, and it worked very well last year when the yen fell 15% before rebounding sharply on a sudden reversal in traders’ positions at the end of 2005. Surprisingly strong signs of growth in the Japanese economy and the first whiffs of inflation persuaded the Bank of Japan to change its monetary policy, analysts say.
Japan’s gross domestic product grew at a 5.5% annual rate in the fourth quarter of 2005, and core consumer prices rose 0.5% year-over-year in January, recording the fourth consecutive monthly gain. The government has exerted pressure on the central bank, however, to avoid a premature tightening, such as occurred in August 2000 when the bank ended its zero-interest-rate policy before the economy was back on its feet.
To overcome deflation and a banking system crisis, the Bank of Japan initiated quantitative easing in March 2001. This meant that the central bank no longer targeted the overnight money market rate, but switched its focus to the level of current-account deposits held by financial institutions at the Bank of Japan, says Toru Umemoto, chief foreign exchange strategist for Japan at Barclays Capital. As a result, the current-account balance at the central bank increased from ¥4.2 trillion in February 2001 to ¥34 trillion in January 2006, he says. The end of quantitative easing will see the Bank of Japan return its policy target to the overnight call rate after gradually easing the current-account level over the next three to six months, according to Umemoto.

While the monetary base in Japan will decrease significantly after the end of quantitative easing, this should have no impact on the economy and financial markets, says Umemoto, because these current-account funds were not used to expand bank lending. The Bank of Japan could raise the overnight call rate to 0.25% some time in the second half of 2006 if the economy continues to expand strongly, he says.

Threat to Global Growth
Funds that flowed into the United States during the period of quantitative ease in Japan could dry up as carry trades are unwound, particularly if the yen were to rally sharply. That, in turn, is raising concern about the ability of the US to fund its deficit and about the impact on global growth, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York.

“The market is now focusing on how the Bank of Japan will engineer a shift without disrupting markets,” Chandler says. Hiroshi Watanabe, vice finance minister for international affairs, indicated recently that the central bank would make sure that the shift in policy wouldn’t cause undue volatility. He also warned that Japan is prepared to intervene in the currency markets if necessary.

David Gilmore, economist and partner at FX Analytics, based in Essex, Connecticut, says the Bank of Japan will be hard pressed to carry out one interest rate increase this year, much less several. The carry trade is not dead, he asserts, it is just not as frothy as it once was. “Furthermore, I am not looking to a cyclical interest-rate or growth story to drive the next big move in the euro, the dollar or the yen,” he says. With the Federal Reserve, the European Central Bank and the Bank of Japan all raising, or getting ready to increase, rates, central bank policy in these countries is somewhat, if not entirely, offsetting, he notes.

The Next Big Move
The next big move for the dollar will come when the focus of market participants switches back to the structural imbalances that demand a lower dollar, according to Gilmore. April could be the month when this theme re-emerges, he says. The US treasury will be compelled in its foreign exchange report to Congress this month to name China as a currency manipulator for failing to let the yuan move more freely, Gilmore says.

Meanwhile, the Group of Seven industrialized countries, which meets in Washington this month, can no longer put off the adjustment process, Gilmore says. It is worth noting that G-7 officials led most of the major turning points in the dollar, such as the Plaza Agreement and the Louvre Accord, he says.

The Plaza Agreement in September 1985 involved coordinated intervention by the Group of Five to sell the dollar. The G-5 agreed at a meeting in New York’s Plaza Hotel that exchange rates should play a role in adjusting external imbalances and that the dollar had become too strong. In the Louvre Accord of February 1987 the major industrial countries agreed, at a meeting in the Louvre Museum in Paris, that the fall in the dollar since the Plaza Agreement had brought their currencies within ranges broadly consistent with underlying economic fundamentals, and the G-7 agreed to stabilize exchange rates.

“The longer the adjustment process is delayed, the more severe the process will be when it comes,” Gilmore says.
Meanwhile, the dollar’s share in world foreign exchange reserves is declining, but only because China does not reveal its rising holdings of dollars, says Brian Reading, economist at Lombard Street Research in London. China now holds 27.8% of total reserves of developing countries, up from 14.9% at the end of 1998, he says, adding that perhaps 90% of Chinese reserves are in dollars.

A new quarterly series from the International Monetary Fund showed that the dollar accounted for 66.4% of total allocated foreign exchange reserves worldwide as of the third quarter of 2005.

“There has long been an expectation that countries would sooner or later diversify their foreign exchange reserve holdings out of dollars,” according to Reading. Following what is happening, or more accurately what has not been happening, has been made a lot easier by the IMF’s release of quarterly figures on the composition of official reserves, he says. For many years, the only source of statistics for the currency composition of countries’ foreign exchange reserves came from IMF annual reports, which were outdated by the time they were published.

There has been no Asian shift out of dollar reserves yet, Reading says. While the IMF never reveals individual countries’ allocations, it publishes the totals for all contributors and the breakdown between industrial and developing countries. Nearly all of the industrial countries contribute data to the IMF, and they divulge what currencies they are holding their reserves in. Developing countries, however, are much more reluctant to disclose such information. Almost half of developing countries’ reported reserves remain unallocated. Meanwhile, three-quarters of the increase in world reserves since the end of 1998 was amassed by developing countries, Reading says. Since China, until July 2005, pegged its yuan currency to the dollar, it is virtually certain that most of its foreign exchange reserves are held in dollars, he says. When 90% of China’s foreign exchange reserves are added to the total of allocated dollar reserves, the combined share of the dollar in total world reserves appears to have fallen only slightly, Reading says.


Currency Forecasts


Gordon Platt