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Weighing The Risks Of The Yen Carry Trade

Currency markets were rattled after Japan's top financial diplomat said investors were underestimating the risks involved in the carry trade, or buying low-interest bonds in Japan to leverage investments elsewhere, including supporting the U.S. housing market.

"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 economist at the Federal Reserve, told CNBC's "Street Signs."

Hiroshi Watanabe, Japan's vice finance minister for international affairs, warned investors that should the yen appreciation at all, the risks associated with the Japanese carry trade increase.

"It's no longer a one-way bet and (Japanese policymakers) were prepared to let the yen rise and people all of a sudden said, 'Oh, there's risk here', " said Posen.

The former Fed economist said the impact of a potential unwinding of the carry trade depend on what the easy money has been used for.

"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," said Posen.

"You've got a bunch of emerging markets, you've got subprime mortgages, a bunch of risky assets which are getting priced as though they have little more risk than U.S. Treasuries."

Although Posen said the situation in Japan was "not as big a deal" as the Russian debt crisis of 1998, volatility is likely to rise in the near term. "I think things are going to be fine, but it's going to be a bumpy couple of weeks," he said.

Meanwhile, the yen continued to gain on the greenback on Thursday, rising to new three-month highs, as currency traders decreased their exposure. Earlier in the week, on Tuesday, the yen surged 2% against the dollar, the biggest one-day jump in 14 months.

Japan's vice finance minister also said on Thursday that yen carry trades were unlikely to reverse quickly. Such trades have swelled in the past year on expectations Japan's interest rates would stay low compared with other industrialized countries.

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