Carried Away

Story Highlights:

• The recent reversal of the yen carry trade can be attributed to a few factors: increased risk aversion, the downturn in markets, and the rising yen.
• Forced and voluntary global deleveraging are causing a big currency move in favor of the yen. To a lesser extent this is happening with the dollar as well.
• Investors around the world who had borrowed yen to invest elsewhere are forced to sell and repay borrowings—lest their loans, denominated in the strengthening yen, become more costly.

____________________________________________________________________________________

Many investors are wondering when the global markets' sell-off will end. Strong gains from rallies here and there have been erased by subsequent down days. Negative news has been followed by positive news followed by negative news. Markets are clearly still sorting through the full effects of the financial crisis. Recently, that sorting has manifested in the currency markets.

Last week saw major moves across global exchange rates. The Japanese yen and US dollar strengthened to record highs as other major currencies, notably the euro and the British pound, fell. The yen posted the sharpest rise against all other currencies last week, including an 8.6% gain against the dollar and 13% against the euro. Yen carry trade investors around the world—those who had borrowed yen to invest elsewhere—were forced to sell and repay borrowings—lest their loans, denominated in the strengthening yen, become more costly.

For years, the carry trade allowed for a financial framework that stretched across the globe. Japan's reliably low interest rate allowed investors in various countries to borrow yen-denominated loans at those nominal rates to buy higher yielding assets such as equities and bonds. This proved profitable as long as Japanese rates remained low the yen remained steady or weakened. It's unknown exactly how much capital is tied up in the yen carry trade, but some estimates have surmised as much as $1 trillion.

The recent reversal of the yen carry trade can be attributed to a few factors: increased risk aversion, the downturn in markets, and the rising yen. These three factors are not mutually exclusive. Carry trade investors fearing market and economic declines are selling out of investments and repaying their yen-denominated loans. At the same time, investors are exchanging large volumes of currency to repay the loans (exchanging whatever currency their investments are denominated in for yen). This heightened demand for yen is pushing it to rise steeply against other currencies. In turn, the strengthening yen and the downturn in markets are making investments purchased with yen-denominated loans less profitable and in some cases very costly. Investors caught in this last scenario are rushing to repay their yen-denominated loans before they lose more money and consequently probably contributing to further global market declines.

As mentioned previously, the yen carry trade proved profitable as long as Japanese interest rates and exchange rates remained steady. Japanese interest rates are still low (0.5%), but forced and voluntary global deleveraging are causing a big adverse currency move in favor of the borrowed currency—the yen. (The US dollar carry trade has also been unwinding but not as much as the yen carry trade.) For many years, the yen was considered a "safe" carry currency since its popularity with investors systematically resulted in a weak yen and its benefits to Japanese exports gave the Japanese government incentive to maintain artificially low interest rates. These recent happenings show how easily currency trends are influenced by the compounding effects of risk appetite or aversion.