COLUMN-Carry trade goes way of all leverage

LONDON (Reuters) - It was fun while it lasted, but the carry trade -- maybe the world's biggest leveraged bet -- is rapidly fading from the scene.

The practice of borrowing in currencies with low interest rates, like the Japanese yen or Swiss franc, and plonking the money into something with a higher rate, or something you just hope will go up, has been estimated at up to $1 trillion (500 billion pounds) in value.

But the great unwinding of debt now underway has made banks too scared to lend much and investors too scared to take on much risk.

Markets have become far more volatile in recent months, raising the risk of losing big money on carry trades, while declining interest rates in markets like the United States rob the trade of some of its potency.

"With lending conditions substantially tighter than last year there will be less of an appetite to fund carry trades," said Simon Derrick, head of currency research at Bank of New York Mellon in London.

"And if investors see less opportunities in high risk markets, (they) don't have to borrow as much."

The carry trade has clearly taken a big knock since financial markets became unstable last summer, as shown in a strengthening yen.

On a trade-weighted basis the yen had been declining since 2000, as investors, or speculators if you prefer, borrowed yen and then sold them to buy anything from New Zealand government bonds to real estate in Hawaii.

But since the summer the yen has strengthened -- some 13 percent against the dollar and substantially against others.

Like so many things now reversing, such as real estate investment, the carry trade was a self-fulfilling momentum trade that works beautifully -- until it doesn't.

Borrowing yen at a half a percent and buying New Zealand two-year bonds yielding more than seven percent is sweet, so long is the money is there to borrow and the yen doesn't strengthen, making your debt bigger.

The momentum has now reversed, and there are good reasons to think the unwinding of carry trades has further to go.

"The days of volatility gradually grinding lower are behind us," Ashley Davies of UBS in Singapore wrote in a note to clients.

"Leveraged carry trade activity will likely remain capped, since investment banks are taking a more cautious approach to managing capital in the aftermath of the subprime crisis."

WHERE HAVE YOU GONE, MRS WATANABE?

One phenomenon of the carry trade was "Mrs Watanabe," the archetypal Japanese housewife who en masse became a force on currency exchanges, often borrowing many times their capital to sell yen and buy Turkish lira or other high yielding assets.

By some estimates such small traders were last summer accounting for up to 25 percent of trading in Tokyo hours.

Using Tokyo Financial Exchange data on margin traders, UBS calculates that shorting the yen by such investors has fallen more than 60 percent from July peaks.

At the same time offshore speculators operating on the Chicago Mercantile Exchange are now betting heavily that the yen will rise, according to UBS, a complete reverse of 2007 and the biggest such bet since 2004 when there were hopes of an economic rebound in Japan.

And the carry trade is not just on the wane in yen. There is also evidence of similar forces at work in Swiss francs, where local interest rates are low and two-year government bonds yield just 2.07 percent.

It has to be said that the unwinding of the carry trade thus far has been pretty orderly: there have been none of the really violent short-term moves the yen saw in 1998 when Russia defaulted and Long-Term Capital Management blew up.

But it is clearly not without risk. While banks are probably keeping their hedge fund clients on relatively short leashes and Mrs Watanabe has retreated, there are others who could get caught out by any future swings in the yen or Swiss franc.

A substantial number of Korean corporations are said to be funding in yen.

And in central and eastern Europe many individuals borrow money in other currencies, usually Swiss francs, in order to finance house purchases at home.

For Hungarian borrowers, for example, that can mean a huge saving in interest, with a 4.5 percentage point gap between 10-year rates in the two countries.

As of November there were some $18 billion of foreign exchange loans to households in Hungary, about evenly split between mortgages and consumer loans.

With the franc having strengthened about six percent against the forint since the fall, those debts have gotten heavier, and could get heavier still.

But regardless of whether these bets come terribly unstuck, the lack of a vibrant carry trade funnelling money will make riskier assets, be it a Budapest apartment or a Turkish bond, less good bets until the crisis has passed.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)