“It is very hard for people to resist instant gratification,” says Buttonwood in The Economist. That’s why the yen carry trade is so popular – “it offers instant rewards”. In this trade, investors borrow money in low-interest-rate Japan and place the cash in foreign assets offering higher income. By doing so, they get a steady income out of the difference between the interest rate they pay and the income they receive.
Everybody from hedge funds to banks is at this, says Nils Pratley in The Guardian; it’s been “the easiest way to call yourself an investment genius in recent years”. However, it’s far from risk-free; a rise in the value of the yen would increase the value of a trader’s yen debt relative to the assets he’s bought and potentially put him in the red. One big rise could wipe out all the income gains he’s made; that’s why cynics describe these bets as “picking up nickels in front of steam rollers”, says Buttonwood. Like maxing out your credit cards, the reward is immediate and it seems the bill can be indefinitely postponed. Payment – in the form of a rally in the yen – must eventually fall due, but traders are betting that they’ll get out in time.
But how important is the carry trade to markets? Very, says Albert Edwards of Dresdner Kleinwort; it “continues to hose global liquidity into ‘risk’ and cyclical assets”. By way of illustration, he points to the chart above, which shows a pronounced correlation between the yen/dollar exchange rate and the MSCI Emerging Markets Index over the past year. This dependence suggests that if the carry trade unwinds, things could get very ugly.
We may already have seen an example of what could happen. “Only once in the past three years has the yen carry bet threatened to turn sour,” says Pratley. In May, the Bank of Japan hinted that its war against deflation might be nearing a close and interest rates could rise. As the currency briefly perked up, traders rushed to exit their carry trade bets. “High-yielding currencies in emerging markets like Turkey tanked, and even the FTSE 100 index fell 11%.”
And though by its standards the yen barely moved that time; historically, once it rebounds, it rebounds very strongly – in 1998, it surged 15% against the dollar in a few days. A move on that scale would make May’s mini-drama look very tame. As Edwards puts it: “Whiplash is likely in the months ahead.”