The carry trade, a major element of the credit bubble of the past few years, is going into reverse. Investors have borrowed currencies of countries with low interest rates (mostly yen in recent years), sold the holdings and bought high-yielding assets, ranging from cash deposits in high-yielding New Zealand to slices of mortgage-backed CDOs. This has “fed the world’s financial markets for years”, says Edward Chancellor on Breakingviews. The size of the yen carry trade, fuelled also by Japanese retail investors seeking higher yields abroad, is about $1.2trn, according to The Daily Telegraph’s Ambrose Evans-Pritchard.
The trade worked with a low and stable yen, but looks less appealing now that yen volatility has risen amid growing risk aversion. So traders have been reversing it, buying yen to repay their loans. As the yen appreciates, losses on the carry trade mount, prompting a rush of unwinding, and hence yen buybacks. The yen gained 4% against the dollar last week, its biggest weekly jump since yen carry trades were liquidated amid the turmoil induced by the LTCM collapse in 1998. It has gained about 20% against the Australian and New Zealand dollars in under a month. Simon Derrick of Bank of New York Mellon thinks the yen’s rally could yet match its 1998 surge, a 14% jump in two days. Speculative bets piled up against the yen ahead of the latest shake-out were well over three times the size of the maximum position in 1998. This sell-off looks equally “brutal”.
Traders will also be forced to sell the assets they had been financing with carry trades, thus pushing down prices; “a lot of funds are selling anything they can to meet margin calls”, says John Mauldin on Investorsinsight.com. Unwinding is set to endure, says Lex in the FT. With riskier assets now on the slide, borrowing yen to invest elsewhere will be less enticing. Meanwhile, Japan’s improved economy points to a stronger currency. In these “times of stress”, the yen – still around 40% below its fair value of ¥85, reckons Tim Lee of Pi Economics – offers the prospect of “significant capital gains”, says Chancellor.