Yen Action Sets Scene for Carry Trade’s Return

The billions of dollars in yen sold by the world’s most powerful central banks have sent a strong message to speculative investors. Those daring to bet that the Japanese currency will again test 76.25 yen, the record high against the dollar it hit last week before the G7’s intervention, better have deep pockets.

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Indeed, now that theworld’s richest nations have pledged to back Tokyo in its efforts to halt the yen’s appreciation, some strategists are predicting a new set of trading patterns in foreign exchange markets. The yen, they say, could make a return as investors’ currency of choice for making so-called “carry trades”.

The carry trade, in which the purchase of riskier, higher-yielding assets is funded by selling low-yielding currencies, is a popular investment employed by investors to take advantage of rising asset markets.

Before the financial crisis, the low-yielding yen was widely used to fund investments in a wide range of risky assets such as equities, commodities, property and higher-yielding currencies such as the Australian dollar. This sent the yen down to multi-year lows against a raft of currencies.

But the wave of deleveraging that followed the credit crunch saw the yen rally sharply as asset prices tumbled. Investors abandoned carry trades funded in the Japanese currency. The yen has risen more than 30 per cent against the dollar since Lehman Brothers’ collapse in 2008.

All that, though, could be about to change if the belief that central banks have imposed a ceiling on the yen gains traction. And a return of the carry trade would have the potential to lift prices of risky assets – equities and commodities are already well into a bull run – even further, analysts say.

“There is another wave of global liquidity in the making, this time coming out of Japan. This liquidity will not stay in Japan and will boost asset prices elsewhere,” says Hans Redeker at BNP Paribas

The impact of currency intervention, if sustained, could have a similar effect to the US Federal Reserve’s preparations in the summer of 2010 for a second round of “quantitative easing”, its huge bond-buying programme to kick-start recovery. The Fed’s action lifted shares and weakened the dollar.

“This time it will be the yen funding another rush into global assets,” says Mr Redeker. “We buy aggressively into risk and see the yen moving lower.”

Mansoor Mohi-uddin at UBS says yen-funded carry trades are likely to make a comeback as other central banks outside Japan prepare to tighten monetary policy while Tokyo keeps conditions ultra-loose to deal with the effects of this month’s earthquake and hold the yen in check.

"This time it will be the yen funding another rush into global assets."" -Global Head of Foreign Exchange Strategy, BNP Paribas, Hans Redeker

The Fed is due to end its “QE2” programme in June, the European Central Bank is expected to raise interest rates as early as next month, while the Bank of England is forecast to tighten policy later this year. The success of a carry trade investment strategy requires not just stability in asset markets, but a steadily weakening funding currency. The joint action from leading central banks to intervene to stem strength in the yen could help to provide both.

Traders cite a range of factors that led to last week’s spike. These include expectations that Japanese institutions would repatriate funds to pay for post-earthquake reconstruction costs and speculative momentum as traders taking advantage of the move upwards forced buying by investors squaring bets against the yen. “Should it have continued, it risked a significant destabilization in the financial and economic foundation of Japan,” says Camilla Sutton at Scotia Capital.

Ms Sutton says the G7 stepped in to weaken the yen, not so much because the value of the Japanese currency had become extreme, but because the yen-dollar trading pattern had become disorderly and threatened global economic and financial stability.

“This type of volatility in currencies threatens much more than the economic recovery of the world’s third-largest economy. Above all the G7’s role was to stabilize global markets,” she says. The action, which drove the yen down to 81 yen, where it has stayed, helped shares recover their poise after a volatile week.

Expectations of further currency intervention to come, combined with the 40,000 billion yen asset purchase programme announced by the Bank of Japan, means yen liquidity can only grow in coming months. Thus, the G7 has stabilized not only the asset side of the yen carry trade, but the funding side, too.

Mr Mohi-uddin says the G7’s efforts to weaken the yen are also likely to succeed because they are consistent with the expectations for future interest rate changes outside Japan. “So investors should should forget about yen strength,” he says.

“Instead carry trades are clearly making a comeback as reduced investor risk aversion following the G7 intervention allows hawkish central banks to consider raising interest rates.”

Of course, any evidence of widespread yen repatriationby Japanese institutions may yet trigger renewed yen strength. For now, though, a return of the carry trade should come as welcome news in Tokyo as Japan tries to rebuild.