Conditions ripe for limited yen carry trade return

LONDON (Reuters) - Conditions are ripe for the yen to regain its role as a global funding currency, but a return to massive yen carry trades may not happen until higher interest rates are firmly established in the United States and elsewhere.

Benchmark interbank dollar lending rates crossed back above yen rates this month for the first time since August last year. Analysts say that could prompt speculators to re-establish yen carry trades -- borrowing the low-yielding Japanese currency to buy higher-yielding assets.

A return to large yen carry trades would also herald yen weakness against the dollar and other currencies.

Since the crossover, the spread has widened to around 46 basis points as the Bank of Japan has eased monetary policy and stood poised to loosen policy further to stem deflation.

But that remains well below the 515 or so basis points seen during 2005-2007, when the dollar rose about 20 yen and the euro gained nearly 40 yen.

A wider spread ensuring lower yen borrowing costs would make yen carry trades more attractive.

"You would need to see a material rise in the interest rates of other countries," said Adam Cole, global head of FX strategy at RBS Capital Markets, who expects the yen to strengthen to around 85 yen in the medium term.

In 1997-98, extremely low or even negative yen interest rates triggered a boom in the yen carry trade, in which global speculators borrowed massive amounts of cheap yen -- some 15 trillion yen ($161.9 billion) at its peak -- to bet on world financial markets.

That was a big factor behind the dollar's rise to 147.64 yen in August 1998 from its record low of 79.75 yen in April 1995.

The spread widened to some 520 basis points at the height of the yen carry trade in late 1998 and grew to around 670 basis points after the BOJ adopted zero interest rates in 2000 and eventually quantitative easing in early 2001.

LOWER RISK

Three-month interbank borrowing costs for yen have also fallen below the Swiss franc -- which has also been widely used as a funding currency -- as the Swiss central bank raised its growth and price outlook this month, indicating it was inching closer to a rate rise.

"The yen will regain its status as the global funding currency of choice, particularly as we see the U.S. recovery starting to pick up and the SNB preparing to hike rates later in the year," said Ian Stannard, senior currency strategist at BNP Paribas.

"The yen will remain a funding currency due to extremely low interest rates and as it stays undervalued against other currencies."

Currency speculators have already piled into long yen positions. But the latest data showed speculators trimmed their long yen positions to 10,161 from 15,197.

Options traders say one-month risk reversals stand near three-year lows for yen calls, indicating a bias for the yen to weaken.

Furthermore, Japanese investors are expected to scoop up foreign assets when the new financial year begins in April.

The dollar was last trading at 93.24 yen after hitting a three-month low of 92.60 yen on Wednesday.

"The yen will likely remain on the back foot against the dollar on higher U.S. bond yields, increasing the attractiveness of the yen as a funding currency," said Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi UFJ.

Analysts at Commerzbank say carry trades tend to accumulate when perceived risk falls notably.

"We expect global risk perception to continue on a low level this year," they said in a research note.

"An above average fall which could lead to a build-up of carry trades is most likely to occur in the summer months," they said, adding that supports their forecasts for the yen to depreciate to 140 yen per euro and 105 yen per dollar.

The Bank for International Settlements said last month foreign exchange derivatives activity surged in the final three months of 2009 with turnover rising to a record high, possibly reflecting an increase in carry trades.

But it had been difficult to establish which currencies were used to fund the trades as a number of countries had low interest rates, it said.

($1=92.64 Yen)

(Graphic by Scott Barber)