Thursday, August 16, 2007

As The Yen Strengthens..

The yen is a weathervane for global funding costs, particularly for market-related speculative leverage, i.e. securities margin. Its ultra-low interest rates have attracted borrowing demand from hedge funds, funds-of-funds and private equity funds from all over the world. At the same time, local Japanese investors have moved out of their own currency in exchange for higher yielding investments abroad. This pushme-pullyou affair that has kept the value of the yen abnormally low vs. the dollar and the euro is, in my opinion, coming to an end.

No one really knows how much money is involved in this strategy, known collectively by the term "yen carry trade". Some put it at a few hundred billion dollars, others think it may involve as much as a trillion or more. Without becoming too esoteric, I think the best picture is provided by the BIS data on yen foreign exchange forward swaps (see chart below, click to enlarge). Bank FX and money market dealers structure their trading books around such swaps and - very importantly - they are considered off-balance sheet items for banks' regulatory and other capital requirements.

Data: Bank for Int'l Settlements

This is not to imply that the yen carry trade involves 4 trillion dollars. There are major non-speculative uses for such swaps, namely funding and hedging commercial transactions like imports/exports, project finance, etc. However, notice the sharp jump from $3 trillion to nearly $4 trillion after 2005, precisely when global markets turned frothy and credit for speculative purposes became very abundant. I don't think this is a coincidence and thus, in my opinion, $1 trillion is a fair estimate for the yen carry trade.

Leveraged finance is now unraveling before our very eyes and cheap yen funding is perhaps the very last straw still poking out of the liquidity pond, providing some low-cost breathing air to those speculators now deeply under water. As the yen strengthens vs. the dollar and euro the carry will produce its own margin calls, further pressuring stretched speculative positions - and that will indeed be "the last straw".

P.S. Several hours after I wrote the above dollar-yen went from 116 to 112. Margin calls must be going unmet and the banks are selling out customer positions. This is going to ricochet throughout all markets for quite a while. Cheap funding no more... there goes the straw.


  1. and that will push the Japanese economy in a very bad situation (GDP was driven by exports). And the swissie should go up as well, even for the moment the swiss currency is not reacting. time will come as well ...and that will be bad for the swiss economy

  2. The question isn't just: Do hedge funds use yen carry to make speculative investments?

    Remember what hedge funds are suppose to do: invest on both the long and short sides of the market to balance risk.

    However, the very high inverse correlation (on a daily basis) between yen and global stocks in 2007 has indicated that most yen carry money is being used to go long speculative stocks.

    I have been saying that the final straw won't just involve an unwind of yen carry. It also will involve a shift in carried positions away from net long to a more neutral mix (i.e., more shorts). The combination will greatly increase market volatility and loss. If this is so, expect the markets to fall sharply even after the yen stabilizes, as carry positions are increased on the short side.

  3. The yen carry trade for the last year or more has been driven mostly by kimono traders searching for higher yields overseas. They have typically been dip buyers, which removed a lot of volatility from the carry trade. The sharp moves today may just be the Japanese retail investors waking up to the turmoil in the US market.

    The Ministry of Finance may start verbal interventions on the Yen if it drops below 107. But, I think traders may drop this as low as 95 before there is a real risk the MOF will intervene. I don't think they want to be seen as currency manipulators with two different curreny bills in Congress. But, if the Yen gets to 95, the US markets will be in tatters and then Congress will be singing a different tune about lending money to the US.

    Be interesting to see if the BOJ will have the moxy to boost rates above .5% like they were planning.

  4. I am deeply concerned that we will see a mass insolvency because of the carry unwinding. I've seen this before on a much smaller scale. A 1 trillion variation call will cause mass devistations on balance sheets in the banking system.