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Recent Market Selloff Puts 'Carry Trade' in Focus

This week's turmoil in the global markets has put the spotlight on arcane investment practice known as carry trade.

Though a buzz word in investment circles, carry trades actually play an important role in global financing and markets.

In simpliest terms, a carry trade is when an investor borrows in a country with low interest rates--like Japan--and uses the money to invest in higher yielding assets elsewhere--like the U.S. The practice, used widely by hedge funds, is a cheap source of funds and finances a range of economic activities, including the U.S. housing market.

In recent years, the robust global economy--along with relatively subdued inflation and historically low volatility--have made carry trades seem less risky and more appealing for investors.

Investor Nervousness

But the recent strengthening of the yen, prompted by a gradual interest-rate increase to 0.5% from 0% by Japan's central bank, has sparked worries that carry trades can go the other way. That nervousness had caused some investors to "unwind" their carry trades, fueling the stock market selloff this week.

"Everybody had been assuming there was a one-way bet on the yen," Adam Posen, senior fellow at the Peterson Institute in Washington and former Fed economist, said on CNBC. "Liquidity is never enough to cause a problem. You actually have to have people doing stupid things with the liquidity and I think that's what people are starting to worry about right now."

Investment gurus say a demise of the practice is unlikely, unless investors lose complete faith in global growth and the U.S. economy. And that's not the case.

"Nothing materially has changed," said Robert Pavlik, chief investment officer of Oaktree Asset Management. "I'm forecasting 2% to 3% growth this year. Inflation is under control. Companies are still seeing high single-digit profit growth."

Japanese finance officials also expressed concerns about the effects on the yen, but say carry trade is not easily reversible.

Worries About Bubble

As the yen has steadily slid to a 21-year low on a trade-weighted and inflation-adjusted basis, the fear is that its weakness is a bubble in danger of collapse like in 1998, when the
dollar fell 24% against the yen in two months on a massive unwinding of carry trades.

Japan's top financial diplomat Hiroshi Watanabe said he was closely monitoring yen carry trades and the impact from their possible reversal. He said investors should not be complacent and recognise two-way risk as discussed at February's Group of Seven meeting.

Analysts expect the pressures for the unwinding of yen carry trades to subside relatively quickly, citing the Bank of Japan's slow approach to tightening and Japan's huge interest rate disadvantage.

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