BEWARE THE UNWINDING OF THE YEN CARRY TRADE

By David Piling 2008-11-03
We are used to the concept that when a butterfly flaps its wings in Brazil all manner of unspeakable things happen in New Jersey and Tunbridge Wells. But many have struggled to understand the link between Mrs Watanabe's mood swings and the price level of exotic currencies, distant equity markets and sundry commodities. What, in short, does a Japanese housewife have to do with the price of tea in China?
Mrs Watanabe is crude shorthand for Japan's $15,000bn pool of savings, the deepest in the world and worth more than the annual economic output of the US. These vast resources are somewhat apocryphally marshalled by Japanese women, who have traditionally held a firm grip on family finances.
In fact, Mrs Watanabe is very crude shorthand indeed: she is just as likely to be Mr Watanabe, the manager of a Japanese life assurance company portfolio, or Mr Smith, an American hedge fund manager, borrowing in yen to buy South African rand, US mortgage-backed securities or tea futures. Whoever, she is, she borrowed cheaply in yen, courtesy of Japan's rock-bottom interest rates – which have been stuck between zero and 0.5 per cent since 1999 – and put the money in higher-yielding assets abroad.

The important thing to know about Mrs Watanabe is that, temporarily at least, she has all but stopped flapping her wings. In the past days, as spectacular moves in global currencies reveal, the carry trade has been violently unwound. With last week's panic retreat from risk assets of almost every description came a dramatic rise in the yen, partially reversed in the past two days on rumours of a Japanese interest rate cut. Even so, the yen was yesterday trading at about Y97 to the dollar, the other “safe haven” currency, against a remarkably steady Y110-Y120 in recent years.
The yen carry trade has not been the only cheap source of liquidity in recent years. But Ashraf Laidi, chief currency strategist at CMC Markets, reckons it has been the biggest. He quotes figures suggesting that Japanese households alone, discounting savings mediated through life assurers and other institutions, have mobilised $500bn in outbound funds. That leaves aside speculators, who have borrowed unknowable amounts of yen to invest abroad, often on highly leveraged terms.
Just as state bank bail-outs risk moral hazard, more recklessness and the need for future bail-outs, so the unwinding of the carry trade carries with it the danger of the next great bubble. In Japan, the central bank appears to have reacted to a rising yen and sinking stock market by contemplating the uncontemplatable: a rate cut. Even the rumour of such has provoked a mini equity rally and a weakening of the currency.
This is poison for the BoJ. It hated having to keep rates low, fearing that cheap money can cause bubbles in real estate, in capital investment and in the carry trade. Its sightings of inflationary danger everywhere provoked mirth among outside experts. But few are laughing now.
The BoJ might feel vindicated. Even so, it may have to do the opposite of what it wants by cutting rates to avoid the danger of sharp economic contraction. The risks are compounded by the renewed danger of deflation, a ghoulish presence for a decade that, thanks to sliding commodity prices, could come back to haunt Japan.
If Japan really is about to reverse course towards zero interest rates, it will once again become the source of almost free money for anyone with an appetite to invest. Worse even than that, says Mr Laidi, is the potential for an even more dangerous dollar carry trade. The Federal Reserve has been desperately cutting rates, and lopped another half point off again yesterday. The nearer US interest rates approach zero, the greater the incentive to move dollars into higher-yielding assets elsewhere.
These gyrations do nothing to solve the underlying problem, which is that Asia has an excess of savers and the US and Europe an excess of spenders. Unless that is solved, the world seems condemned to repeat the swings of recent years, as capital is arbitraged between countries where money is cheap to those where it is expensive.
Until recently, one of Mrs Watanabe's favourite wheezes was to take her Japanese yen and put them in Australian dollars, earning her a roughly six-point interest rate gain. This week, she – and those who travel with her – will not have missed the fact that Iceland just raised its interest rate to 18 per cent. That is a 17.5 point differential with Japan, and counting. Krona, anyone?