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.