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The Next Yen Carry Trade?

(July 15, 2010)

Dear Subscribers and Readers,

On the surface, the current level of the US$/Japanese Yen seems to have discounted most of the potentially bearish news in the U.S., and potentially good news from Japan.  As can been seen in the following chart, the US$/Yen is now near its November 2009 high, or its highest level since April 1995:

With the ongoing deflationary trend in Japan, it seems like it's a matter of time before the Bank of Japan enters into a “quantitative easing” strategy.  But the ongoing “tug of war” between the Bank of Japan and the government (in where the former has constantly accused the latter on spending on wasteful infrastructure) has resulted in a “non-activist” Japanese monetary policy.  In fact, the year-over-year increase in the Japanese monetary base has been relatively low at 3.6% at the end of June 2010, as shown in the following chart:

Subscribers should note that the US$/Yen exchange rate has historically been correlated with the differential in the US and Japan short-term rates.  As a result, we should focus on relative interest rates around the world rather than the attractiveness of global "risky assets," or in this case, the Japanese monetary base.  Why is the carry trade immensely attractive to hedge funds?  Answer: Many hedge funds possess no real investment talent and so the carry trade is an easy trade for them where they could charge "2/20" - then retire before or when their funds blow up. 

Looking at the big picture, the carry trade has been the main driver of the Yen for the past 15 years and I do not anticipate that to change anytime soon, especially given that: 1) Global financial flows are still dominated by hedge funds looking for "easy" yield; note that even though global macro funds are not a big group in absolute terms, they trade very frequently and use an immense amount of leverage (via futures, options, or credit default swaps) - so they still dominate global financial flows vs. flows related to global trade, and 2) The demographics of Japan suggests that Japanese investors will continue to look for incremental yield, as opposed to investing in global equities.

From the mid-1990s to 1998, the yen carry trade was mostly between the USD and the Yen, driven by significant easing by the Bank of Japan, coupled with an immense technological boom in the US - the latter of which increased the appetite for US assets across the board, including US Treasuries as the Federal Reserve maintained a relatively tight policy, at least relative to Japan's.  From the early 2000s to 2007, the yen carry trade was driven by strength in the Euro, in addition to strength of developed commodity countries such as Australia and New Zealand - both of which maintained tight monetary policies given their strong domestic economies.  This trade is now over, especially given that (German) short rates in the Euro Zone are now similar to those of Japan's, while countries such as Greece and Portugal are now suffering from default/liquidity risk.  In addition, the Euro-Yen cross rate (as shown in the below chart) is still in a downtrend, despite the fact that it's now at an 8-year low:


So the $64 trillion question is: What will be the main driver of the next Yen carry trade?  Again, we need to focus on the hedge funds and Japanese domestic investors/housewives.  As mentioned, US$/Yen trade is that attractive.  Rather, I think one should short the Yen (i.e. use the Yen as a funding currency) and go long various Asian currencies whose countries have strong government and household balance sheets.  Political uncertainty aside many countries now have very strong balance sheets and demographics - both of which should lead to a consumer-driven boom going forward (as an aside, there is always some risk involved – in the mid-1990s, the “risk” was overvaluation of US equities, while in the mid-2000s, the unprecedented rise in commodity prices – the like of which has not occurred since the late 1970s/1980).  No doubt the various Asian central banks would maintain a tight policy in light of this development (Asian countries are already tightening monetary policies as we speak).  This should increase the attractiveness of the Yen-interAsian currency trade.  In addition, one could pick up a few percentage points of yield from this carry trade - which you can't pick up by shorting the Yen and going long the US$.  Asian/Pacific countries whose currencies look attractive relative to the Yen include those of Malaysia, Indonesia, Thailand, and India.  On the other hand, I will ignore Australia and China.

Signing off,

Henry To, CFA

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