Last year, the carry trade, whereby investors borrow money in low-yielding currencies, sell it, and park the funds in riskier, higher-yielding assets, was all the rage. Now, with risk aversion on the rise as global markets tank amid the darkening economic outlook and credit jitters, these trades are being unwound and higher-yielding currencies have been under pressure.
“The real test of carry-trade activity is the relationship between the yen and the New Zealand dollar,” says Neil Dennis in the FT. The yen fell 15% against the Kiwi in the first eight months of 2007 as the yield on the latter reached 8.25%, against 0.5% in Japan. But the Kiwi has relinquished almost all these gains, losing 4% last week as investors unwinding their carry trades have bought back their borrowed yen.
The yen and the Swiss franc, another popular carry-trade funding currency, have gained a respective 7% and 4% against the euro since the start of the year, while the dollar last week hit two-and-a-half-year lows against the yen and a record low against the franc. Until the markets calm down, “risk aversion will keep causing yen buying”, says Michiyoshi Kato of Mizuho Corporate Bank.
Asian currencies have also been buffeted as sliding regional equity markets have prompted foreign investors to ditch stocks. Sterling hasn’t been looking too good either, hitting a ten-month low against the greenback this week and a record low against the euro earlier this month.
Over the past few days, however, the main theme has been euro weakness. The prospect of aggressive rate cuts in the US and the European Central Bank’s hawkish tone hit the dollar earlier this month. But the euro is now at a one-month low against the dollar as Europe’s deteriorating fundamentals presage lower rates.
Investors have been rattled by European Central Bank (ECB) council member Nout Wellink, who said last week that growth in the eurozone economy looked set to slow to 1.5% this year, as opposed to the 2.5% officials expect, as US weakness took its toll. The ECB’s quarterly lending survey reported the worst balance since 2003 of loan officers tightening conditions for corporate, housing and consumer credit, says Lex in the FT.
Meanwhile, according to Royal Bank of Scotland, manufacturing has slipped into its first recession since 2001 – and German investors’ confidence has hit a 16-year low. RBS’s David Simmons says “there is no chance” of Europe decoupling from the US and the European economy is already slowing down… the next move in European interest rates is down. Sell it – that’s my advice on the euro.”
Longer-term, tensions between eurozone members also look likely to undermine confidence in the single currency. Now the property bubbles in Ireland and the Mediterranean are bursting, these states will call for lower interest rates, while Germany, where rail workers have just won an 11% pay rise – is traditionally more hawkish. France and Italy are close to breaching spending limits with budget deficits near 3% of GDP, and may thus be forced to tighten into a downturn. As BNP Paribas notes, “while tensions can be camouflaged during upswings, they surface during downswings. All failed currency unions were abandoned during times of economic stress.”