Carry Trading Tirade

Today we discuss the reason du jour for the recent stock market weakness:

The Big Bet That Could Melt Wall Street: A look at the 'Yen Carry Trade' and Why so Many Investors Are Starting to Worry it Might Unravel
By Grace Wong, CNNMoney
https://money.cnn.com/2007/03/05/markets/yen_carry/index.htm?postversion=2007030610

Financial analysts have been hemming and hawing about the yen carry trade for months, if not years. This is without doubt one of the most priced in financial worries of the recent past. Many said the yen carry trade was the culprit behind last year's stock correction in May, it was obsessively cited as the reason stocks were going up in the back half of the year, it was the reason the world was awash in liquidity, and also it was the biggest risk facing markets. So, people think it's a big deal. But is it?

The yen carry trade is the idea that investors have been borrowing yen at a low interest rate and using the funds to buy higher-yielding assets based in other currencies.

There is probably some truth the trades are "unwinding" because the BoJ raised rates two weeks ago, making the yen carry trade on the margin less attractive than before. Short term interest rates in Japan are still ultra-low compared to the rest of the developed world at about 0.5%. That's compared to 5.25% in the US and 3.5% in Europe. Borrowing costs in Japan remain significantly below yields and expected returns of innumerable investment opportunities around the world. A 0.25% change isn't a huge swing in fundamentals—certainly not enough to collapse world equity markets.

This is a bit of a chicken and egg issue. Are the higher rates leading investors to payback borrowed money in Japan by selling overseas assets and thereby causing them to go down; or conversely, are markets elsewhere declining for some other reason, causing yen borrowers to get nervous and unwind the carry trade? It's impossible to know for sure. It's impossible to even measure the magnitude of the yen carry trade. The people probably (although also impossible to know for sure) doing the most yen carry trading are the Japanese themselves—only the biggest and most sophisticated foreign financial entities will actually borrow in yen and invest elsewhere. This isn't the stuff of your average armchair investor.

Since borrowing costs are still exceptionally low in Japan, we don't suspect there will be a complete elimination of yen carry trade positions, and even a material decline would probably reverse once jitters work their way out of the market because the interest rates differentials remain so wide.

But none of this really has much to do with global stock markets. Yet again, loose correlations are being drawn where likely there is no meaningful relationship. A week's worth of data tells us nothing. There's little relationship between the movement of oil and stocks, and currency movements are probably in the same category. The US dollar was down in 2004 and up in 2005 and down again in 2006…stocks were up all three years.

All this talk about the yen has us confused anyway. Just a few months ago everyone in the financial press was saying the weak dollar was the reason stocks would fall…now it's the yen's strength? Make up your minds people! And what about the euro, is that just chopped liver? Maybe currencies should start demanding equal time from the press as a market worry, just to be fair and balanced.

There have been plenty of times when the yen has been strong and stocks have done fine. A recent example: the yen strengthened sharply from February 2006 through May 2006—a period where stocks performed very well.

Currencies are not particularly stable, specifically over short periods of time. People who actually engage in the yen carry trade are by definition taking part in currency risk. If you borrow yen at 0.5% and buy an asset in dollars with a yield of 5.25% you keep the spread of 4.75%, right? That's actually not nearly as attractive as it might seem because currencies can (and often do!) move by that much in a matter of a few days or weeks! It's not as if this is just automatic free money—you can still lose your shirt. Besides, if it were truly "free" money…wouldn't everyone engage in it and arbitrage the spread away within a matter of hours? Free money cannot last long—the market is too efficient. There are good reasons to believe the carry trade is in fact risky.

But the media panders this idea that suddenly investors are "realizing" that currencies can move quickly so everyone's panicking and buying back yen to cover their debts. It's as if the hedge funds and other large institutional investors that may or may not be engaging in the carry trade are just now figuring out that risk is a factor in investing with currencies. This is insane. As we've stated before, the proliferation of financial markets and derivatives are proof people are managing risk better than ever before (see our past commentary "Deriving Stable Markets").

Lastly, the Bank for International Settlements reported that yen borrowing by foreigners was $650 billion as of June 2006. That's up only $160 billion from June 2004. Once you adjust for hedging activities, yen borrowing by foreign parties is basically inconsequential on the global scene that sees trillions of dollars change hands daily.

More than ever, we're confident this is a typical bull market correction for stocks. And though the markets surged today there could very well be more downside—corrections last on average at least a couple months. Either way, the explanations (psychology) just aren't matching the fundamentals and basic economic truths out there. Stick to your guns and stay bullish for 2007.