No end in sight for yen carry craze

LONDON Wed Feb 21, 2007 10:34am EST

Japanese 10,000 yen bank notes and coins are displayed March 3, 2006. High risk yen carry trades exploiting Japan's low interest rates are in no danger of losing their appeal as long as Japanese monetary policy remains predictable and financial market volatility stays low. REUTERS/Toshiyuki Aizawa

Japanese 10,000 yen bank notes and coins are displayed March 3, 2006. High risk yen carry trades exploiting Japan's low interest rates are in no danger of losing their appeal as long as Japanese monetary policy remains predictable and financial market volatility stays low.

Credit: Reuters/Toshiyuki Aizawa

LONDON (Reuters) - High risk yen carry trades exploiting Japan's low interest rates are in no danger of losing their appeal as long as Japanese monetary policy remains predictable and financial market volatility stays low.

The BOJ raised rates to a decade high of 0.5 percent on Wednesday, saying it would tighten borrowing costs further but gradually.

Japan's rates are still the lowest in the industrialized world and the yen quickly erased initial gains to resume a broad decline, hitting a record low against the euro beyond 159.

Carry trades, where investors borrow in currencies with low interest rates and invest the proceeds in high yielding currencies, are seen by many as an unsustainable long-term strategy that can only thrive in a low-volatility environment with ample cheap money.

But investors seem eager to amass ever more yen-financed positions in higher yielding assets.

"We are again in a framework where carry trades work very well. As long as expectations of BOJ hikes remain moderate then shorting yen may be still in the market for some time," said Umberto Alvisi, currency strategist at Credit Suisse.

"There is fairly low volatility in the market. At a global macro level we are in an acceptable path of economic growth. It doesn't appear we have a big inflation or big growth issue."

Capital flows out of Japan have also contributed to the yen's weakness reflecting a structural shift in the behavior of domestic investors that is also likely to help keep the yen on a downward trend.

"There is a declining home bias -- investors are thinking they have to have a larger exposure overseas, some of which come in the form of carry trades," said Stephen Jen, chief currency economist at Morgan Stanley.

Morgan Stanley estimates there have been monthly outflows of around $2 billion by Japanese retail investors buying overseas "uridashi" bonds, issued in foreign currency terms. It also estimates outflows from investment trust funds denominated in foreign currencies total around $10-13 billion a month.

"These flows may not be cyclical, they can be structural," Jen said. "It can go on for quite a while until...the world turns round and realizes they have too little exposure to the Nikkei or other Japanese assets."

BOJ Governor Toshihiko Fukui said on Wednesday not all aspects of yen weakness could be described as the product of market distortion given the role of higher Japanese investment overseas.

WHAT SHOCKS?

The success of carry trades stems from low financial market volatility, especially in currencies, with investors exploiting a vast pool of liquidity put in place via steep interest rate cuts after the technology bubble burst in 2000 and Sept 11, 2001 attacks on the United States.

Policymakers have warned one-way bets in carry trades can be dangerous and that risks are under-priced. But analysts say markets have grown more robust, in part thanks to central banks.

"We had oil shocks, terrorist shocks... we had all the shocks we can imagine. But we don't know how to price it. It's not clear these things matter in financial markets. We are not easily perturbed by shocks," Jen said.

"They (central banks) haven't messed up," he added. "(Some of them) are now telling the world what they are going to do. That's predictability. That reduced volatility in interest rates, which in turn has supported carry trades."

FLOUTING THEORY

The peculiar thing about carry trades as a lucrative bet is they flout an economic theory that says currencies with high interest rates should weaken versus those with lower rates.

The concept of interest rate parity, which dictates pricing in the currency forward market, says the difference between the spot price and the forward price of a currency rate should equal the interest rate gap between the two countries.

If it doesn't, by definition, it should be arbitraged.

The theory effectively says rate premia exist precisely to compensate for the risk of long-term depreciation inherent in a currency plagued by high inflation or big trade deficits etc.

However, this has not always been the best market bet.

Citigroup strategists, for example, cites academic studies showing that in the post-1973 floating exchange rate period investors in money-market instruments denominated in currencies with high interest rates have outperformed.

"Occasional shocks in the high interest rate currency country disrupt this trade, but do not brutalize it," they said.

Jen said a long-term econometric analysis shows selling a currency with low interest rates has proved more profitable.

"Forward bias tells you carry trades over a long extended period are profitable. Forward bias has worked spectacularly well and that's very convincing and the trend is still there."