The Yen carry trade is teetering, so where do things go from here?
While most eyes are on Europe and the United States to gauge where the global financial system is going, many are unaware of a storm that has been brewing in Japan since around 1999.
The Yen carry trade has been winding up for the best part of 30 years and, like a game of Buckaroo in its later stages, it is expected to come to a very abrupt end at any moment.
Japan had a major asset bubble burst in 1999, forcing the Bank of Japan (BoJ) to slash its interest rates to 0%.
This prompted Japanese investment funds to look for global investment opportunities as they were handed a double whammy of investment tools: zero cost to borrow the money and much higher interest rates in foreign markets.
Foreign investors cotton on
It didn’t take long for traders and investors all over the world to see what was going on in Japan and start running the same game. The arbitrage (the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset) opportunity was significant as the difference in US, Australia and New Zealand interest rates in particular – the carry – afforded a licence to print money when hundreds of billions were being borrowed.
There was a peak in the carry trade around 2004-2007 as the Yen became the “funding currency of choice” right up until until the global financial crash in 2008.
Shinzo Abe revives the deal
Shinzo Abe got voted in at PM of Japan for a second term in 2012 after serving his first term from 2006 to 2007. His bold monetary policy, which involved a huge round of quantitative easing by the BoJ (otherwise known as inflation), is lauded for lifting Japan out of decade’s worth of deflationary stagnation.
He made the Yen available and kept the interest rate at near 0%. This has been the case up until the present day, where the the carry trade is a hair trigger away from unwinding.
The effect of the unwinding
As with any market that has been gradually moving in one direction for a very long time, the shift in the other direction usually happens far more explosively and very often with catastrophic effect, as often over-leveraged investors rush to exit positions like wildebeest trying to cross a crocodile infested river.
Two facets of the unwinding would be Japan raising rates and conversely, other countries cutting rates. It’s not a difficult maths problem to see that the arbitrage could become too small or even negligible in very short order should both of these happen simultaneously.
If the Yen then strengthens, investors having to convert back to it from US dollars, for example, would then be losing money hand over fist on the exchange rate. The selling of assets bought in Yen would most likely lead to the selling off of US treasuries, global equities and commodities as the rush to convert back to the Yen to pay off the borrowed money starts to snowball, and prices plummet.
Paper assets go to zero
As I’ve said before, there is an increasing perceived danger of holding paper assets that have no real value behind them. At the same time asset prices (particularly gold and silver) are hitting new highs on an almost daily basis.
Personally, I’m a big fan of being able to hold something of value in my hand. The Yen carry trade is one of many financial houses of cards that could collapse at any moment, so, in my view, it pays to be positioned before these things happen.
NOTE: This is the opinion of this columnist and should not be seen as independent investment advice.
