Hedge Funds:Turning Current Yen Into Old Ruble?

Remember the collapse of the Russian ruble in 1998--that led to the near-collapse of hedge fund giant Long Term Capital Management? Recent trends in the Japanese yen have investors worried that the currency is destined for a similar fate as befell the ruble. `

The yen is currently floating around a 4-year low against the U.S. dollar and already hit a record low against the euro earlier this week. And, like in 1998, there is significant worry that hedge funds are to blame for the yen’s weakness – the only difference being that in 1998 when the ruble collapsed, there were only a handful of private equity firms around. Now, there are hundreds.

Jack Crooks of the Sovereign Society, and David Gilmore of Foreign Exchange Analytics discussed the relationship between the Japanese yen and hedge funds – and the possibility of a yen collapse – on “Morning Call.”

Crooks says the conditions are in place for a major correction in the yen, mostly because of the vast amounts of liquidity – nearly $1 trillion he believes – behind the yen carry trade.

In brief, the yen carry trade is when investors - in this case primarily hedge funds - borrow yen at its relatively cheap interest rate of 1% and then buy a different currency (like Indonesia's rupiah, which yields about 10%) in an attempt to make money off the difference in rates. Any currency’s carry trade can be risky due to the constant volatility in exchange rates. The yen carry trade is particularly so because the currency is so weak.

Gilmore agrees that the liquidity yen carry trade is massive, but he doesn’t see a tipping point just yet. He says hedge funds have dynamic risk management systems in place to make sure a 1998 repeat doesn’t happen (although, nothing is fail-safe in the world of private equity).

Crooks notes that the Chinese stock market is down nearly 10% this week which signals to him that Asian investors are nervous. And regardless of whether or not there’s a full-blown collapse of the yen, he says there is no question that hedge funds’ role in the yen carry trade is the reason for its profound weakness.

But it isn’t only hedge funds that are involved in the carry trade. Japanese retailers are too (as is anyone who shorts the yen, Gilmore says) - since they can’t get any yield domestically, they go elsewhere. Japan’s own Ministry of Finance has over $800 billion in reserves, which makes it the biggest component of the carry trade out there, Gilmore says. It’s creating a dynamic and volatile situation in the already unstable currency market. But the Japanese government has too much of a vested interest in protecting against a rapid appreciation of its currency to let it happen. Japan’s an export-led economy and its government is not going to sit by and watch its currency “explode,” Gilmore says.

World leaders are expected to discuss the weakness in the yen during next week’s G7 meeting in Essen, Germany.