Shift in Japan's Monetary Policy Threatens to Reduce the Appeal of Lucrative Yen "Carry Trade"

By Platt, Gordon | Global Finance, April 2006 | Go to article overview

Shift in Japan's Monetary Policy Threatens to Reduce the Appeal of Lucrative Yen "Carry Trade"


Platt, Gordon, Global Finance


The logic couldn't be simpler. An investor borrows Japanese yen at a low interest rate and invests the proceeds in US treasury bonds or higher-yielding emerging market bonds. The interest-rate differential provides an easy route to arbitrage yield gains. This so-called "carry trade" has been very popular with hedge funds and other global investors in recent years, but the gravy train could be nearing the end of the line.

The Bank of Japan voted last month to end its quantitative easing policy, preparing the way for an eventual increase in interest rates. This means that the yen carry trade will become less attractive and more risky, since the Japanese currency might rise, analysts say. A rising yen would make it more expensive to pay back these loans at the same time that the yield differential, or potential profit, would narrow if Japanese rates rise.

The massive unwinding of the yen carry trade could prove to be the most significant development in the foreign exchange market in the first half of this year, says Dennis Gartman, editor and publisher of the Gartman Letter, a Virginia-based investment advisory service. "We must remember that the market has been layering on the yen carry trade for the past several years," he says. "It has helped to finance speculation in gold, base metals, grain, oil, stocks in North America, Europe and Asia." According to Gartman, "The unwinding of such enormous positions shall either be done slowly and over a great deal of time and likely in tears, or it shall be done swiftly, massively and accompanied not only by tears, but also by a great deal of pain."

Analysts say the Bank of Japan is aware of the size of the carry trade, however, and will move very cautiously in shifting monetary policy in order to minimize the potentially destabilizing effect of a reversal in capital flows on global financial and asset markets, as well as to make sure that its tightening doesn't snuff out the nascent Japanese economic recovery.

Global Glut in Funds

"I would imagine that the adjustment in the markets will be a longer-term process, rather than a crisis," says Robbert Van Batenburg, head of global research at Louis Capital Markets, a New York-based broker-dealer of equities and derivatives. "There is still a lot of easy money around," he says.

There is a global glut in investment capital and an increased appetite for risk, as reflected in narrow spreads of corporate bonds to US treasury securities and of emerging market debt to treasuries, Van Batenburg says. "Emerging markets are benefiting from global growth, and money is flowing into raw materials, gold, natural gas and other resources because the real economy is growing so fast," he says.

If the yen-carry trade is unwound, hedge funds could redeploy these funds in the equity markets, benefiting stock prices, according to Van Batenburg. And if the US yield curve were to get steeper as the result of Japanese or Chinese investors withdrawing funds from the bond market, which could force up yields, this could benefit US banks, which have been hurt by the flat yield curve, he says.

"I think there is a very low likelihood of a scenario in which there would be blood in the streets,"Van Batenburg says, "but an event in the past of similar magnitude is hard to imagine. It could have a similar effect to revaluation of the Chinese yuan."The Japanese and Chinese central banks have accumulated $1.6 trillion in foreign exchange reserves, and normally the dollar would have declined as a result, he says. Instead, Japan and China have kept their currencies undervalued, he notes. Now hedge funds and other investors will need to purchase yen to unwind their carry trades. If the yen were to rise too quickly, the Bank of Japan would intervene at the behest of the Japanese Ministry of Finance to buy dollars and restrain the yen's rise, he says.

"The yen carry trade is not done yet," says Brian Dolan, director of research at GAIN Capital, Bedminster, New Jersey-based provider of foreign exchange services, including direct-access trading and asset management. …

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