Is This The End of the Yen Carry Trade?

With the global economy worsening and on-track for a world-wide recession – see yesterday’s Forex News and Rumors for an update from the International Monetary Fund (IMF) – we may be witnessing the end of the yen carry trade for the foreseeable future. The reason for this is quite simple – as the G7 countries continue to lower interest rates, the advantages of carry trades based on the yen are greatly diminished.

Essentially, a carry trade is a transaction that seeks to profit on the interest differential between two currencies. One of the most common carry trades involved borrowing Japanese yen which has had a very low interest rate for most of the past two decades, and then using the low-cost yen to acquire higher-yielding currencies such as the Australian or New Zealand dollar. You can learn more about the mechanics of a carry trade by reading this article on the FXPedia website.

Recent Events Minimizing Carry Trade Profitability

As interest rates fall in many in the G7 countries to combat their slowing economies, the potential to gain on the interest rate differential is reduced. A quick look at the benchmark lending rates for the United States, the European Union, and England shows how much rates have dropped in the last quarter including yesterday’s whopping one and half percentage cut by the Bank of England.

Even Australia and New Zealand who have historically maintained rates in the six and seven percent range have lowered their rates as well.

Despite the convergence of interest rates, what may be an even greater factor in the abandonment of the yen carry trade, is the tremendous volatility now occurring in the currency markets. The yen has made impressive gains against the euro and pound in particular and analysts are predicting that the yen will continue to appreciate. This adds considerable risk to open carry trades as a change in exchange rates could quickly add to losses, and this added risk is forcing investors to reconsider – and even close-out – their carry trade positions.

What Will Happen As All These Trades Are Unwound?

As investors eliminate carry trades – or “unwind” them to use industry parlance – there will be an increasing demand for the yen as investors sell their foreign currency holdings in order to repay the yen-based loans. This in itself will cause the yen to appreciate further.

One of the results of this appreciation is that Japanese exports will become more expensive to foreign buyers resulting in weaker demand for Japan’s goods. As one of the world’s largest exporters, this would be catastrophic to the Japanese economy, leading to reduced growth and even deflation. In order to deal with the slowing economy, you might expect Japan to turn to the standard practice of reducing interest rates to induce spending and devalue the currency. But for Japan, this course of action is really not available.

Throughout the 1970s and 1980s, Japan posted large trade surpluses and this, combined with high personal savings, contributed to an appreciation of the yen against most other currencies. Ultimately, this led to rampant speculation resulting in the infamous Japanese “Asset Bubble”. Japan’s superheated economy finally came back to earth in the early 1990s plunging the country into a deep recession.

While fighting the recession, Japan has followed a course of low interest rates – a policy that continues today. In fact, the Bank of Japan recently cut the lending rate from 0.5% to 0.3% earlier this week. Yes, you read that right – 0.3%.

That really doesn’t leave the Bank of Japan with much room to operate. If the demand for the yen explodes as many predict, we could see the beginning of another asset bubble with the Bank unable to do anything but watch helplessly from the sidelines.

Other Possibilities

How about a dollar carry trade or even a cable carry trade? The US interest rate is now at a measly 1.0 percent with talk of another 50 basis point cut before the end of the year. The British pound is at 3.0 percent and deeper cuts are expected. Neither currency is expected to appreciate as much as the yen so will we see investors borrowing US dollars at 0.5 percent to go long New Zealand dollars where interest rates remain at 6.5 percent?

This could be disastrous for the dollar – imagine the effect selling of billions of dollars in order to buy kiwi dollars would have on the value of the greenback. Don’t think that those currently unwinding their yen carry trades aren’t already thinking along these lines as they need some place to park all that cash.