The Japanese central bank raised interest rates to 0.5% earlier this week. That may not sound like much, but it means the key Japanese interest rate is now at its highest level since 1998. However, the greatest impact of the decision is likely to be felt well beyond Japanese shores.
In tightening its grip on the economy, the Bank of Japan also runs the risk of triggering a major unwinding of ‘carry trades’, whereby speculators borrow in cheap yen to invest in higher-yielding currencies, such as the New Zealand dollar. This trade has depressed the yen’s value on foreign exchanges and fuelled a global credit bubble, says Martin Hutchinson on Breakingviews.
Nobody knows exactly how big the carry trade is. Estimates based on short-term net foreign lending of Japanese banks put it at $200bn. This is vastly understated, says The Economist, as a large amount of the traffic in carry trades is conducted through off-balance-sheet transactions by hedge funds. It believes the figure is closer to $1trn.
The last time the carry trade built up this way in the financial system was in 1998, say Peter Garnham and Gillian Tett in the FT. Then, the strategy unwound in dramatic fashion in the wake of the Russian financial crisis, pushing the yen up 13% in three days and ultimately contributing to the collapse of US hedge fund Long Term Capital Management.
So what might cause the trade to unwind this time round? The main catalyst is unlikely to be rising interest rates, says The Economist. Rates would have to rise more than two percentage points before carry trades stopped making sense. Instead, an upsurge in currency volatility is more likely to cause problems.
The yen is currently trading around its lowest level “since at least 1970”, according to a JP Morgan index. As long as the yen stays weak, then carry trades are profitable. However, a bounce in the currency – sparked perhaps by unexpectedly good news from Japan, or even bad news from the US – could “trigger a vicious spiral of yen strength and the unwinding of carry trades”, says Capital Economics.
For now, the Bank of Japan’s assurances that further rate rises will be gradual have helped to keep the yen weak. But if Japan’s economic recovery continues, it’s only a matter of time before the yen rallies. “Some day someone is going to lose an awful lot of money betting on a continuing weak yen,” warns Roger Bootle in The Daily Telegraph.